GAO-05-1009SP i

Contents

Preface 1

Introduction 4

Section 1

Revenue—

Taxes Exist to 

Fund 

Government

7

The Current Tax System 7

Historical Trends in Tax Revenue 13

Historical Trends in Federal Spending 14

Borrowing versus Taxing as a Source of 

Resources 15

Long-term Fiscal Challenge 17

Revenue Effects of Federal Tax

Policy Changes 19

General Options Suggested for Fundamental 

Tax Reform 21

Key Questions 22

Section 2

Criteria for a 

Good Tax 

System

24

Equity 26

Equity Principles 26

Measuring Who Pays: Distributional

Analysis 30

Key Questions 33

Economic Efficiency 35

Taxes and Economic Decision Making 37

Measuring Economic Efficiency 40

Taxing Work and Savings Decisions 41

Realizing Efficiency Gains 43

Key Questions 43

Simplicity, Transparency, and 

Administrability 45

Simplicity 45

Transparency 47

Administrability 49
Contents

ii GAO-05-1009SP

Trade-offs between Equity, Economic Efficiency, 

and Simplicity, Transparency, and 

Administrability 52

Key Questions 52

Section 3

Transitioning 

to a Different 

Tax System

54

Deciding if Transition Relief Is Necessary 54

Identifying Affected Parties 55

Revenue Effects of Transition Relief 56

Policy Tools for Implementing 

Transition Rules 56

Key Questions 57

Appendixes Appendix I: Key Questions 58

Section I: Revenue Needs—Taxes Exist to Fund 

Government 58

Section II: Criteria for a Good Tax System 59

Equity 59

Efficiency 60

Simplicity, Transparency, and 

Administrability 61

Section III: Transitioning to a Different Tax 

System 62

Appendix II: Selected Bibliography and 

Related Reports 63

Government Accountability Office 63

Congressional Budget Office 63

Other Selected Sources 64

Appendix III: Glossary 66

Tables Table 1: Features of the Current Tax System 8

Table 2: The 10 Largest Tax Expenditures in 

2004, Outlay Equivalent Estimates 12

Table 3: Measures of Tax Burden, Distribution 

of Total Federal Taxes and Individual 

Income Taxes in 2004 32
Contents

GAO-05-1009SP iii

Table 4: The Corporate Tax Rate Schedule: 

Simple but Not Transparent 49

Figures Figure 1: Issues to Consider When Assessing 

Alternative Tax Proposals 4

Figure 2: Revenue Overview 7

Figure 3: Sum of Tax Expenditure 

Outlay-Equivalent Estimates 

Compared to Discretionary 

Spending, 1981-2004 11

Figure 4: Federal Revenue as a Percentage of 

GDP and by Source, 1962-2004 14

Figure 5: Federal Spending as a Percentage of 

GDP and by Spending Category, 

1962–2004 15

Figure 6: Federal Tax Revenue versus Federal 

Spending, 1962–2004 16

Figure 7: Composition of Federal Spending as 

a Share of GDP, Assuming 

Discretionary Spending Grows with 

GDP after 2004 and That Expiring 

Tax Provisions Are Extended 18

Figure 8: Formula for Determining Tax 

Revenue 19

Figure 9: Trade-offs in the Criteria for 

Assessing Tax Reform 24

Figure 10: Equity Overview 26

Figure 11: Efficiency Costs Are One Cost 

Taxpayers Face in Complying with 

the Tax System 36

Figure 12: Efficiency Overview 37

Figure 13: Simplicity, Transparency, and 

Administrability Overview 45

Figure 14: Compliance Burden Is One Cost 

Taxpayers Face in Complying with 

the Tax System 46
Contents

iv GAO-05-1009SP

Figure 15: Taxpayer Noncompliance 

Categorized by Amount of 

Withholding and Information 

Reporting, 1992 51

Figure 16: Transition Issues Overview 54

This is a work of the U.S. government and is not subject to 

copyright protection in the United States. It may be reproduced 

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However, because this work may contain copyrighted images or 

other material, permission from the copyright holder may be 

necessary if you wish to reproduce this material separately.
GAO-05-1009SP 1

Preface

Taxes are necessary because they fund the services provided by government. In 2005, 

Americans will pay about $2.1 trillion in combined federal taxes, including income, 

payroll, and excise taxes, or about 16.8 percent of gross domestic product.

Beyond funding government, the federal tax system has profound effects on the 

economy as a whole and on individual taxpayers, both for today and tomorrow. Taxes 

change people’s behavior and influence the economy by altering incentives to work, 

consume, save, and invest. This, in turn, affects economic growth and future 

income—and thus future government revenues. At the same time, the current tax 

system generates fierce controversy over fairness—who should pay and how much 

they should pay. In addition, the current tax system is widely viewed as overly 

complex, thereby reducing the ability of individuals to understand and comply with 

the tax laws. Furthermore, the tax system is costly to administer with most of the 

costs of administration, such as record keeping, understanding the laws, and 

preparing returns, borne by taxpayers.

Concerns about the economic effectiveness, fairness, and growing complexity of the 

current tax system raise questions about its credibility. These concerns have led to a 

growing debate about the fundamental design of the federal tax system. The debate 

includes the type of base—income or consumption—and the rate structure—flatter 

or more progressive. Additionally, some question to what extent and how the tax 

system should be used to influence economic behavior and social policy. 

Some see tax rates as too high—discouraging work, savings, and investment and 

consequently slowing economic growth. At the same time, the myriad of tax 

deductions, credits, special rates, and so forth cause taxpayers to doubt the fairness 

of the tax system because they do not know whether those with the same ability to 

pay actually pay the same amount of tax. In addition, tax expenditures, also called tax 

preferences, just like spending programs, can lead to higher tax rates over time. 

Complexity and the lack of transparency that it can create exacerbate doubts about 

the current tax system’s fairness. Public confidence in the nation’s tax laws and tax 

administration is critical because we rely heavily on a system of voluntary 

compliance. If taxpayers do not believe that the tax system is credible, is easy to 

understand, and treats everyone fairly, then voluntary compliance is likely to decline.

The debate about the fundamental design of the tax system is occurring at a time 

when the nation also faces large current deficits and a significant and structural longterm fiscal imbalance. Long-term budget simulations by GAO, the Congressional 

Budget Office, the Office of Management and Budget, and nongovernment analysts 

show that absent policy changes, the federal budget is on an unsustainable path. 

Known demographic trends and rising health care costs will cause ultimately 
Preface 

 2 GAO-05-1009SP 

unsustainable deficits and debt that will threaten our national security as well as the 

standard of living for the American people in the future. 

While additional economic growth is critical and can help to ease the burden, the 

projected fiscal gap is so great that it is unrealistic to expect that growth alone will 

solve the problem. Ultimately, the nation will have to decide what it wants from the 

federal government, that is, what level of spending do we want on programs, tax 

preferences, and other government services and how we will pay for that spending. 

Clearly, tough choices will be required. Addressing the projected fiscal gap will 

prompt policymakers to examine the advisability, which includes both the 

effectiveness and affordability, of a broad range of existing programs and policies 

throughout the entire federal budget—spanning discretionary spending, mandatory 

spending, entitlement programs, tax expenditures tax rates, and tax system design. 

This examination will likely result in actions affecting both tax revenues and tax 

expenditures.

The background, criteria, and questions presented in this report are designed to aid 

policymakers and the public in thinking about how to develop tax policy for the 21st

century. This report, while not intended to break new conceptual ground, brings 

together a number of topics that tax experts have identified as those that should be 

considered when evaluating tax policy. This report attempts to provide information 

about these topics in a clear, concise, and easily understandable manner for a 

nontechnical audience. In developing this report, we relied on government studies, 

academic articles, and the advice of tax experts to provide us with information on the 

issues surrounding the tax reform debate. For a short bibliography of related 

publications, see appendix II. For easy reference, key terms are defined in the 

glossary located in appendix III—these glossary terms appear in bold type the first 

time they are used in the text. 

This publication was prepared under the direction of James R. White, Director, 

Strategic Issues (Tax Policy and Administration Issues), who may be reached at (202) 

512-9110 or WhiteJ@gao.gov. Contact points for our Offices of Congressional 

Relations and Public Affairs may be found on the last page of this report. Kevin Daly,
Preface

GAO-05-1009SP 3

Tom Gilbert, Don Marples, Donna Miller, Ed Nannenhorn, and Amy Rosewarne made 

key contributions. This report will be available at no charge on the GAO Web site at 

http://www.gao.gov. 

David M. Walker

Comptroller General 

of the United States
 4 GAO-05-1009SP 

Introduction

This report provides background information, criteria, and key questions for 

assessing the pros and cons of tax reform proposals, both proposals for a major 

overhaul of the current federal tax system and incremental changes to the system. 

Figure 1 outlines the key issues that we address. First, we discuss how the size and 

role of the federal government drive the government’s revenue needs. Second, we 

describe a set of widely accepted criteria for assessing alternative tax proposals. 

These criteria include the equity, or fairness, of the tax system; the economic 

efficiency, or neutrality, of the system; and the simplicity, transparency, and 

administrability of the system. The weight one places on each of these criteria is a 

value judgment and will vary among individuals. As we note, there are trade-offs to 

consider among these criteria, and we discuss how these criteria can sometimes be in 

conflict with each other. Finally, we turn to a consideration of the issues involved in 

transitioning from the current tax system to an alternative tax system. 

Figure 1: Issues to Consider When Assessing Alternative Tax Proposals

Sources: GAO (text); PhotoDisc, IRS (images).

Transition effects

• Equity 

• Economic efficiency 

• Simplicity, transparency, 

 and administrability

Criteria for a good tax system:

Revenue

ssues to consider when thinking 

about tax system changes:

I
Introduction

GAO-05-1009SP 5

The primary purpose of the tax system is to collect the revenue needed to fund the 

operations of the federal government, including its promises and commitments. Tax 

revenues may not fully match government spending each year, but over time, the 

federal government needs to be able to raise sufficient revenue to cover its current 

and expected financial obligations. Decisions about spending and the role of 

government have a direct impact on the government’s ultimate revenue needs. 

Whether the resources to fund government spending are provided through taxes or 

borrowing has consequences for the economy and the federal budget. Borrowing 

(which has often led to budget deficits) may be appropriate for federal investiment 

such as building roads and scientic research, and during times of recession, war, and 

other temporary challenges. However, federal borrowing also absorbs scarce savings 

that would otherwise be available for growth-enhancing private investment. In 

addition, large amounts of borrowing may increase the share of interest payments in 

the federal budget overtime, placing additional pressure on future budgets.

One’s view about the equity of a tax system is based on subjective judgments about 

the fairness of the distribution of tax burdens. The actual burden of a tax—the 

reduction in economic well-being caused by the tax—is not always borne by the 

people who pay the tax to the government because tax burdens can be shifted to 

other parties. For example, the burden of a tax on business can sometimes be shifted 

to consumers by increasing prices or to workers by decreasing wages. Public debates 

regarding the equity of the tax system reflect a range of opinions about who should 

pay taxes and how much of the tax burden should be shouldered by different types of 

taxpayers. 

Taxes impose efficiency costs by altering taxpayers’ behavior, inducing them to shift 

resources from higher valued uses to lower valued uses in an effort to reduce tax 

liability. This change in behavior can cause a reduction in taxpayers’ well-being that, 

for example, may include lost production (or income) and consumption 

opportunities. Efficiency costs, along with the tax liability paid to the government and 

the costs of complying with tax laws, are part of the total cost of taxes to taxpayers. 

One of the goals of tax policy, but not the only goal, is to minimize compliance and 

efficiency costs. The extent to which efficiency costs can be reduced by reforming 

the tax system depends on the design features of the new tax system, such as the 

nature and number of any tax preferences. 

Simplicity, transparency, and administrability are related but different characteristics 

of a tax system. Simplicity is a gauge of the time and other resources taxpayers spend 

to comply with the tax laws. This includes the time and resources spent on record 

keeping, learning about tax obligations, and preparing tax returns. The transparency 

of a tax system refers to taxpayers’ ability to understand how their liabilities are 

calculated, the logic behind the tax laws, what their own tax burden and that of 

others is, and the likelihood of facing penalties for noncompliance. Administrability 

refers to the costs, ultimately borne by taxpayers, of collecting and processing tax 
Introduction

 6 GAO-05-1009SP 

payments as well as to the costs of enforcing the tax laws. While simplicity, 

transparency, and administrability are related concepts, they are not the same thing. 

A very simple tax rule may not be transparent if the rationale for the rule is not clear. 

Similarly, not all simple taxes are easy to administer. 

Designing tax policy requires making trade-offs among these criteria. For example, a 

proposal to improve the efficiency and simplicity of the tax code may involve 

eliminating exemptions or deductions originally introduced to improve the equity 

of the system. Moreover, some criteria include subjective elements. One individual’s 

perception of the equity of a tax proposal can differ from another’s. However, being 

subjective or objective does not make a criterion superior. 

In addition to determining the type of tax system, policymakers also determine the 

amount of revenue to be raised, which involves balancing the costs of taxes against 

the benefits of government services. Despite the fact that no tax system is perfectly 

fair, efficient, simple, transparent, and without administrative costs, in general people 

are willing to pay taxes and bear the other costs of the tax system because they desire 

the benefits of government and understand that sufficient tax resources are 

necessary for a sound fiscal policy in the long term.

Finally, because moving to an alternative tax system creates winners and losers, 

transition rules may be included in tax reform proposals to mitigate some of the 

windfall gains and windfall losses that are likely to occur. However, debate exists 

as to whether transition rules, which are usually proposed on equity grounds, are 

appropriate because they may also reduce the efficiency of the tax system and 

temporarily make the tax system more complex. 

Tax reform proposals can range from small changes to the tax code to more 

comprehensive changes. The issues and questions we discuss in this report are 

designed to apply to both incremental changes to the tax system, such as changing 

tax expenditures to encourage savings, and to more comprehensive tax reform 

proposals, such as switching from a predominantly income-based tax to a 

consumption tax base. 

In addition to discussing the criteria used to evaluate changes to the tax system, this 

report provides information about economic and budgetary trends, the current tax 

system, and definitions of important tax concepts. For each section of the report, we 

provide a set of key questions designed to help identify the important features of the 

proposals This is information that we believe would be useful for evaluating the 

proposals and identifying limitations of the data and analysis.
GAO-05-1009SP 7

Revenue—Taxes Exist to Fund 

Government Secotin1

Taxes exist to fund the services provided and the promises made by the government. 

Since tax revenue may not match spending in each year, the resources needed to fund 

government can be also be raised by borrowing (deficit financing). Both taxes and 

borrowing affect economic performance. Taxes can affect the economy because they 

alter decision making by people and businesses. Federal borrowing absorbs savings 

otherwise available for private investment and postpones the need to tax or reduce 

spending. (See fig. 2.)

Figure 2: Revenue Overview 

The Current Tax System

The federal tax system in the United States primarily consists of five types of taxes: 

(1) personal income taxes; (2) social insurance taxes (employee and employer 

contributions for Social Security, Medicare, and unemployment compensation); (3) 

corporate income taxes; (4) estate and gift taxes; and (5) excise taxes based on 

the value of goods and services sold and other taxes. The tax bases, rates, and 

collection points of the major federal taxes are summarized in table 1.

Sources: GAO (text); PhotoDisc (images).

 ssues to 

consider when 

identifying the 

government’s 

revenue needs and 

how the tax system 

will be structured to 

fund the services 

provided by the 

government:

The current tax system

Historical trends in tax revenue

Historical trends in spending

Borrowing versus taxing

Long-term fiscal challenges

Revenue effects of policy changes

Possible options for tax reform Transition effects

• Equity 

• Economic efficiency 

• Simplicity, transparency, 

 and administrability

Criteria for a good tax system:

Revenue

ssues to consider when thinking 

about tax system changes:

I
Section 1: Revenue—Taxes Exist to Fund Government

 8 GAO-05-1009SP 

Table 1: Features of the Current Tax System

Type of tax Tax base Tax rates Collection points

Personal income 

taxes (PIT)

Regular PIT

Personal income, 

including income from 

wages, interest and 

dividends, capital gains, 

and small business 

income. 

Numerous tax 

expenditures exist that 

reduce the size of the 

tax base.

Regular PIT

Graduated rate structure:

Statutory marginal rates 

of 10%, 15%, 25%, 28%, 

33%, and 35%. 

Deductions and other tax 

expenditures, such as 

refundable tax credits 

like the Earned Income 

Tax Credit, create a 

group of taxpayers who 

have no tax liability or a 

negative tax liability.

Regular PIT

Employers withhold 

payments, but 

individuals file tax 

returns wherein they 

are also required to 

disclose nonwage 

income and remit 

appropriate taxes. 

Small business owners 

self-report income and 

remit taxes to the 

government.

Personal alternative 

minimum tax (AMT)

Taxable income 

exceeding certain 

threshold amounts 

based on filing status.

Personal AMT

26% or 28% depending 

on taxable income 

subject to the AMT. 

Individuals are eligible 

for a credit for a portion 

of the AMT paid in a prior 

year.

Personal AMT

Individuals compare 

their regular PIT 

liability to their AMT 

liability and pay the 

greater of the two (less 

taxes previously 

withheld or paid during 

the year).

Corporate income 

taxes (CIT) 

Regular CIT

Corporate profits (total 

revenues less total 

expenses). Numerous 

tax expenditures exist 

that reduce the size of 

the tax base.

Regular CIT

Statutory marginal rates 

range from 15% to 35%. 

Regular CIT

Corporations file tax 

returns and remit 

payment to the 

government.

Corporate AMT

Broader definition of the 

tax base (corporate 

income) than regular 

CIT; less generous 

accounting rules.

Corporate AMT

20% for all corporate 

income subject to the tax 

less the AMT credit for 

that tax year.

Corporate AMT

Corporations compare 

regular CIT to 

corporate AMT liability 

and pay the greater of 

the two.

Social insurance 

taxes

Social security

First $90,000 of 

employee wages.

Social security

6.2% employee 

contribution.

6.2% employer 

contribution.

12.4% for self-employed.

Social security

Employers withhold 

taxes from employee 

paychecks.

The self-employed 

remit taxes 

themselves.

Medicare

All wages.

Medicare

1.45% employee 

contribution.

1.45% employer 

contribution.

2.90% for self-employed.

Medicare

Employers withhold 

taxes from employee 

paychecks. The selfemployed remit taxes 

themselves.
Section 1: Revenue—Taxes Exist to Fund Government

GAO-05-1009SP 9

Source: GAO analysis of Internal Revenue Service information.

The revenue raised by the major federal taxes is determined by the size of their bases, 

their rates, and their levels of compliance. In addition, each tax base is affected by the 

size and growth rate of the economy.

Although called income taxes, the current federal individual and corporate income 

taxes have some features characteristic of a consumption tax. The current income 

tax system taxes the income of individuals and corporations, such as wages, interest, 

dividend income, capital gains, and other types of business income, including that 

of sole proprietorships and partnerships. (Some income is double taxed—corporate 

Unified transfer tax—

estate, gift, and 

generation skipping 

tax (GST) 

Estate tax

Fair market value of the 

decedent’s cash and 

securities, real estate, 

trusts, annuities, 

business interests, and 

other assets included in 

the decedent’s estate at 

death less allowable 

deductions in excess of 

$1.5 million in 2005. 

There is an unlimited 

deduction for transfers 

to a surviving spouse.

Estate tax

Rates range from 45% to 

47% in 2005. As a result 

of recent tax legislation, 

estate tax rates will 

fluctuate before the 

estate tax is eliminated in 

2010. However, the 

estate tax will be 

reinstated in 2011.

Estate tax

Decedent’s estate is 

responsible for filing 

returns and remitting 

payment to the 

government.

Gift tax

Tax is imposed on the 

value of lifetime taxable 

transfers of gifts of 

property. Applicable 

exclusion amount of

$1 million for 2005. In 

addition, there is an 

annual exclusion of 

$11,000 per donee and 

an unlimited exclusion 

for tuition and medical 

payments.

Gift tax

Rates range from 41% 

to 47% in 2005. Rates 

fluctuate in the same 

manner as for the estate 

tax in coming years. Gift 

tax will be retained 

following repeal of estate 

and GST.

Gift tax

Gift donor is 

responsible for filing 

returns and remitting 

payment to the 

government.

GST

Total generation 

skipping transfers (such 

as from a grandparent 

to a grandchild) in 

excess of $1.5 million in 

2005.

GST

47% (or highest statutory 

marginal tax rate for the 

estate tax) in 2005. GST 

rates decrease until the 

tax is repealed in 2010. 

GST is reinstated in 

2011.

GST

Depending on the form 

of the generation 

skipping transfer, gift 

donor, donee trustee, 

or decedent’s estate is 

responsible for filing 

returns and remitting 

payment to the 

government.

Excise and other 

taxes

Selected goods, 

services, and other 

items (i.e., gasoline, 

alcoholic beverages, 

tobacco, airline tickets, 

etc.).

Various rates apply to 

different goods, services, 

and other items.

Generally collected by 

businesses, which 

remit payments to the 

government on a 

quarterly basis.

(Continued From Previous Page)

Type of tax Tax base Tax rates Collection points
Section 1: Revenue—Taxes Exist to Fund Government

 10 GAO-05-1009SP 

earnings are subject to the corporate income tax and are taxed again under the 

individual income tax when they are distributed as dividends or as realized capital 

gains when shareholders sell their stock.) However, some income is treated as it 

would be under a consumption tax where income that is saved or invested is 

exempted from tax until it is consumed. For example, up to certain limits, income 

that is contributed to individual retirement accounts and defined contribution 

pension plans is tax-deferred during accumulation. The result is a hybrid incomeconsumption tax base wherein some types of savings and investment are exempt 

from taxation, but other types are not. 

The current tax system includes tax expenditures, also called tax preferences, which 

reduce the size of the tax base. Tax expenditures are usually justified on the grounds 

that they promote certain social or economic goals. They grant special tax relief 

(through deductions, credits, exemptions, etc.) that encourages certain types of 

behavior by taxpayers or aids taxpayers in certain circumstances. Tax expenditures 

can promote a wide range of goals. For example, individual retirement accounts, 

discussed above, promote the goal of increased personal savings and investment, and 

the tax expenditures for owner-occupied homes encourage homeownership. 

Summing one measure of tax expenditures, called outlay-equivalents, indicates that 

the aggregate value of tax expenditures was about $850 billion in fiscal year 2004. 

Outlay-equivalents are budget outlays that would be required to provide the taxpayers 

who receive the tax expenditures with the same after-tax income as would be 

received through the tax expenditures.1

 As an indication of the size and impact of tax 

expenditures, figure 3 compares them to discretionary spending. In some years the 

outlay-equivalents for income tax expenditures exceeded federal discretionary 

spending.

1

Summing outlay equivalent estimates is controversial because doing so does not take into account 

possible interactions among tax expenditures. In addition, there are several ways to define and measure 

tax expenditures. The size of a tax preference can change over time. For example, accelerated depreciation 

of machinery and equipment drops out of the list of the top 10 tax expenditures in 2006. Moreover, what is 

considered a tax expenditure depends on the tax base. Some provisions of the tax code that are considered 

tax expenditures under an income tax base would not be considered tax expenditures under a 

consumption tax base. For further information on how tax expenditures are defined and measured, see 

GAO, Government Performance and Accountability: Tax Expenditures Represent a Substantial Federal 

Commitment and Need to Be Reexamined, GAO-05-690 (forthcoming).
Section 1: Revenue—Taxes Exist to Fund Government

GAO-05-1009SP 11

Figure 3: Sum of Tax Expenditure Outlay-Equivalent Estimates Compared to Discretionary 

Spending, 1981-2004

A few large income tax expenditures account for most of the aggregate value. The 10 

tax expenditures listed in table 2 accounted for over 60 percent of the outlayequivalents in fiscal year 2004. The estimates in the table are for income tax 

expenditures. They do not include provisions that exclude income from other taxes, 

such as payroll taxes. For example, the income tax exclusion for health care 

permits the value of health insurance premiums to be excluded from employees’ 

taxable earnings and also excludes this value from the calculation of Social Security 

and Medicare payroll taxes for both employees and employers.

0

500

600

700

800

900

1,000

Tax expenditure outlay-equivalent estimates

Discretionary spending

Fiscal year

Dollars in billions (in constant 2004 dollars) 

//

Source: GAO analysis of OMB budget reports on tax expenditures, fiscal years 1983-2006.

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004
Section 1: Revenue—Taxes Exist to Fund Government

 12 GAO-05-1009SP 

Table 2: The 10 Largest Tax Expenditures in 2004, Outlay Equivalent Estimates

Source: GAO analysis of Office of Management and Budget (OMB), Budget of the United States Government, Fiscal Year 2006, Analytical 

Perspectives.

In the current tax system, tax rates vary across types of tax. Individual income and 

corporate income above certain levels are generally taxed at graduated rates. Taxes 

on individual income have six statutory marginal tax rates (the rate of tax paid on 

the next dollar of income that a taxpayer earns), ranging from 10 percent to 35 

percent. Income earned by corporations has a statutory marginal rate structure that 

ranges from 15 percent to 35 percent. A separate rate structure exists for the 

individual Alternative Minimum Tax (AMT)—a tax on individual income that was 

originally designed to keep taxpayers with higher incomes from taking advantage of 

various tax provisions in order to pay little or no income tax. The current tax system 

also includes social insurance taxes, which are applied to wages at flat rates and 

remitted in equal shares by employees and employers. However, currently the first 

$90,000 of an individual’s wages is subject to payroll taxes for Social Security, while 

all wages are subject to payroll taxes for Medicare. 

The government’s administrative burden and taxpayers’ compliance burden vary 

depending on the type of taxpayer, the type of tax, and the collection point of the 

tax. For the individual income tax and social insurance taxes, the primary collection 

point occurs at the business level: employers bear the burden of withholding 

employees’ taxes from their wages and remitting the tax payments to the government. 

However, all individuals with income above certain thresholds based on personal 

allowances and a standard deduction still must file tax returns. The Internal 

Revenue Service (IRS) bears the administrative burden of monitoring taxpayer 

compliance and applying penalties to noncompliant taxpayers when necessary.

Dollars in billions

Tax preference

Outlay 

equivalents

Exclusion of employer contributions to medical insurance premiums and medical care $126.7

Deductibility of mortgage interest on owner-occupied homes 61.5

Net exclusion of pension contributions and earnings: 401(k) 58.2

Net exclusion of pension contributions and earnings: employer plans 57.3

Deductibility of nonbusiness state and local taxes (other than on owner-occupied 

homes) 45.3

Accelerated depreciation of machinery and equipment 44.7

Exclusion of interest on public purpose state and local debt 37.5

Capital gains (other than agriculture, timber, iron ore, and coal) 35.9

Capital gains exclusion on home sales 35.0

Exclusion of net imputed rental income on owner-occupied homes 32.8
Section 1: Revenue—Taxes Exist to Fund Government

GAO-05-1009SP 13

Historical Trends in Tax Revenue

Total federal tax revenues have fluctuated from roughly 16 to 21 percent of gross 

domestic product (GDP) over the last 43 years. In figure 4, total federal revenue is 

highest in 2000 at 20.9 percent of GDP and lowest in 2004 at 16.3 percent of GDP. 

As figure 4 also illustrates, there have been important changes to the composition of 

federal revenues over the last 43 years. Corporate and excise tax receipts as a 

percentage of GDP have declined since 1960, while social insurance tax receipts have 

grown. The individual income tax and social insurance taxes have accounted for the 

majority of federal revenues during this period.
Section 1: Revenue—Taxes Exist to Fund Government

 14 GAO-05-1009SP 

Figure 4: Federal Revenue as a Percentage of GDP and by Source, 1962-2004 

Historical Trends in Federal Spending

As figure 5 illustrates, over the last 43 years, federal spending as a portion of GDP has 

ranged from a low of 17.2 percent of GDP in 1965 to a high of 23.5 percent of GDP in 

1983. In addition, figure 5 illustrates that as is the case with revenues, important 

changes to the composition of federal spending have occurred. For example, since 

1962, the total share of federal spending devoted to national defense has decreased 

relative to the share devoted to Social Security and health care. Government 

Fiscal year

Percentage of GDP

GDP 

($11.6 trillion)

16.3%

of GDP

Total 2004 taxes 

as a percentage 

of GDP

($1.9 trillion) 1.6% Corporate income taxes ($189 million)

1.3% Excise and other taxes ($148 million)

6.3% Social insurance taxes ($733 million)

7.0% Individual income taxes ($809 million)

Taxes used to finance government provision of 

services to the public

(numbers do not add to 16.3% due to rounding)

0

5

10

15

20

25

1962

1970

1980

1990

2000

2004

Total revenue

Source: GAO represenation of OMB data.

Individual income taxes

Corporate income taxes

Social insurance taxes

Excise and other taxes
Section 1: Revenue—Taxes Exist to Fund Government

GAO-05-1009SP 15

provision of Social Security and health care accounted for over 40 percent of 

government spending in 2004, a dramatic increase from the share before 1965 when 

the Medicare and Medicaid programs were enacted. 

Figure 5: Federal Spending as a Percentage of GDP and by Spending Category, 1962–2004

Borrowing versus Taxing as a Source of Resources

The resources to fund government are raised primarily through taxes. However, 

borrowing is another source. Figure 6 combines figures 4 and 5 to show that the 

federal government has generally run a deficit in recent decades. 

0

5

10

15

20

25 Percentage of GDP

1962

1970

1980

1990

2000

2004

Fiscal year

Source: GAO representation of OMB data.

National defense

Social Security

Medicare and Medicaid

Nondefense discretionary

Net interest

Other mandatory

Total spending
Section 1: Revenue—Taxes Exist to Fund Government

 16 GAO-05-1009SP 

Figure 6: Federal Tax Revenue versus Federal Spending, 1962–2004

Public sector resources, whether from taxes or borrowing, make the benefits of 

government possible. However, taxes and borrowing also have costs. Obviously, they 

transfer money from the pockets of the public to the government. But they also affect 

the performance of the economy. As will be discussed under the criteria for a good 

tax system, taxes affect the performance of the economy by altering decisions, such 

as how much to work and save, what to consume, and where to invest.

Federal borrowing has advantages and disadvantages that vary depending on 

economic circumstances. Borrowing, in lieu of higher taxes or lower government 

spending, may be viewed as appropriate during times of economic recession, war, or 

other temporary challenges. Federal borrowing might also be viewed as appropriate 

for federal investment, such as building roads, training workers, and conducting 

scientific research, that contributes to the nation’s capital stock and productivity. If 

well chosen, such activities could ultimately help produce a larger economy. 

However, if not well chosen, such spending could displace more productive private 

sector investments.

Federal borrowing also can impose significant costs and risks. Borrowing for 

additional spending or lower taxes for current consumption improves short-term 

well-being for today’s workers and taxpayers, but does not enhance our ability to 

15.0

0

17.5

20.0

22.5

25.0

Year

Percentage of GDP

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

20002002

2004

Source: GAO representation of OMB data.

//

Revenue

Spending
Section 1: Revenue—Taxes Exist to Fund Government

GAO-05-1009SP 17

repay the borrowing in the future. In the near term, federal borrowing also absorbs 

scarce savings available for private investment and can exert upward pressure on 

interest rates. Over the long term, federal borrowing that restrains economic growth 

will also restrain the standard of living of future workers and taxpayers.

Long-term Fiscal Challenge

As discussed in our report on challenges facing the government, the fiscal policies in 

place today—absent substantive entitlement reform and changes in tax and 

spending policies—will result in large, escalating, and persistent deficits that are 

economically unsustainable over the long term.2

 In other words, given current 

forcasts for growth, government spending and resources, today’s policies cannot 

continue and must change. 

Over the next few decades, as the baby boom generation retires, federal spending on 

retirement and health programs, such as Social Security, Medicare, and Medicaid, will 

grow dramatically and bind the nation’s fiscal future. Absent policy changes on the 

spending and/or revenue sides of the budget, a growing imbalance between federal 

spending and tax revenues will mean escalating and ultimately unsustainable federal 

deficits and debt. For example, as figure 7 indicates, if discretionary spending grows 

at the same rate as the economy and all expiring tax provisions are extended, federal 

revenues could be adequate to cover little more than interest on the federal debt by 

2040.

2

GAO, 21st Century Challenges: Reexamining the Base of the Federal Government, GAO-05-325SP

(Washington, D.C.: February 2005).
Section 1: Revenue—Taxes Exist to Fund Government

 18 GAO-05-1009SP 

Figure 7: Composition of Federal Spending as a Share of GDP, Assuming Discretionary Spending 

Grows with GDP after 2004 and That Expiring Tax Provisions Are Extended

Notes: This figure is based on the assumption that discretionary spending grows at the same rate as GDP 

after 2004 and that expiring tax provisions are extended. Despite our assumption that expiring tax 

provisions are extended, revenue as a share of GDP increases through 2015 due to (1) real bracket creep, 

(2) more taxpayers being subject to the AMT, and (3) increased revenue from tax-deferred retirement 

accounts. After 2015, revenue as a share of GDP is held constant.

Regardless of the assumptions used, reasonable long-term simulations indicate that 

the problem is too big to be solved by economic growth alone or by making modest 

changes to existing spending and tax policies. While entitlement reform as well as 

mandatory and discretionary spending cuts will likely be needed to close the longterm financial gap, the structure of the tax system should also be part of the debate as 

policymakers grapple with the nation’s long-term fiscal challenge. As part of this 

process, consideration could be given to improving taxpayer compliance and 

enforcement efforts, expanding the tax base, increasing current tax rates and tax 

rates on future generations, or a combination of these. 

0

10

20

30

40

50

2004 2015 2030 2040

Percentage of GDP

Fiscal year

Revenue

Social Security

Net interest

Medicare and Medicaid

All other spending

Source: GAO representation of OMB data.
Section 1: Revenue—Taxes Exist to Fund Government

GAO-05-1009SP 19

Revenue Effects of Federal Tax Policy Changes

The amount of revenue raised from a tax is determined by the tax base, the tax rate, 

and the compliance rate, as shown in figure 8. Changes to the tax code can be 

revenue neutral, meaning that they are designed to raise the same amount of 

revenue as the current tax laws, or tax code changes can be designed to raise more or 

less revenue than the current tax laws. Additionally, changes to the federal tax system 

can have significant implications for state and local government tax revenues. 

Figure 8: Formula for Determining Tax Revenue

Tax revenue can be affected by changing the current tax base, which could include 

replacing it with a pure consumption tax base or broadening the current tax base by 

eliminating certain tax expenditures. As we noted earlier, tax expenditures, which the 

government uses to encourage specific social and economic goals, reduce the size of 

the tax base. Tax expenditures may be justified because, in some cases, it may be less 

costly to achieve these goals through reductions to the tax base than through 

spending programs. The choice of whether to use tax expenditures or spending 

depends on which approach better targets and meets the program’s objectives at the 

lowest cost. Even though spending programs show up in the federal budget and tax 

expenditures are not included as federal spending, taxpayers are paying for the 

program in either case. Both should be transparent and subject to periodic oversight 

concerning such factors as whether they meet the program’s objectives or conflict 

with other government programs, grants, and regulations that have similar objectives. 

Source: GAO.

Tax base Tax rates Tax revenue Compliance

rate +

+

=

In general, the size of the tax base and the rates applied to that base will determine the 

amount of revenue that the government collects. Tax revenue is also affected by the level of 

taxpayer compliance; the greater the level of compliance, the more revenue is collected for a 

given tax rate and tax base. Thus, tax revenue is the product of the tax base, the tax rate, 

and compliance rates.
Section 1: Revenue—Taxes Exist to Fund Government

 20 GAO-05-1009SP 

The tax expenditure for employer-provided health care, discussed in text box 1, 

illustrates the importance of such oversight. 

Tax revenue can also be affected by changes in tax rates, where the amount collected 

depends on the definition of the tax base and taxpayer responses to changes in the 

rate. If the tax base is broad with few exclusions, deductions, and credits, then the tax 

rates required to generate a particular amount of revenue will be lower than if the 

base is narrow. The Tax Reform Act of 1986 broadened the current tax base, which is 

based largely on income, by eliminating some tax expenditures, which made more 

income taxable. Without any changes in rates, tax revenue would have increased, but 

instead, rates were lowered to keep revenue about the same. Within some range, rate 

increases bring in more revenue, but rates can become so high that a further increase 

discourages enough of the taxed activity to reduce revenue. A tax system is more 

adaptable to increased revenue needs to the extent that tax rates can be increased 

without other fundamental changes to the system and without excessively 

discouraging the taxed activity or increasing noncompliance.

Tax revenue is also affected by policies that change compliance rates. 

Noncompliance means that only part of the tax liability actually gets paid. Increasing 

compliance would bring in more revenue from the existing tax base without having to 

raise rates. IRS estimates that the net tax gap (the difference between taxes legally 

Text Box 1: Tax Expenditure for Employer Medical Insurance Premiums and Medical Care 

The current U.S. tax system excludes employer-provided health insurance from individuals’ taxable 

income even though such insurance is a form of income (noncash compensation). As table 2 showed, 

the Treasury Department estimates that the tax subsidy for employer-provided health insurance was 

over $126 billion in outlay-equivalents during 2004, not including forgone social insurance taxes and 

state taxes.

The tax exclusion increases the proportion of the population covered by health insurance. Currently, 

nearly 45 million Americans are without health insurance. The tax exclusion encourages employers to 

offer and employees to participate in health insurance plans, increasing the proportion of workers 

covered. The exclusion addresses a well-known problem with health insurance. Because individuals 

may be better able to anticipate their health care needs than insurers, health care plans may attract 

customers with higher risk of poor health, resulting in higher premiums. By encouraging the pooling of 

high- and low-risk individuals, the tax exclusion may help to reduce premiums below those that 

individuals would face if they purchased insurance on their own. 

However, some question whether the tax subsidy for health insurance is the best way to increase health 

insurance coverage. For example, the tax exclusion provides the most assistance to taxpayers who 

have high marginal tax rates (those with high incomes)—the exclusion saves those taxpayers more in 

taxes owed than it saves those with lower marginal tax rates. 

The tax exclusion for health insurance also contributes to higher health care costs. The exclusion, by 

lowering premiums, encourages more extensive insurance coverage, which compounds another wellknown problem with health insurance. Because much of the cost of medical treatment is paid for by a 

third party (the insurer), patients and doctors are generally unaware of the total costs of health care and 

have little incentive to economize on health care spending. 

Unlike the tax exclusion for employer-provided health insurance, an ideal health care payment system 

would foster the delivery of care that is both effective and efficient, resulting in better value for the 

dollars spent on health care.
Section 1: Revenue—Taxes Exist to Fund Government

GAO-05-1009SP 21

owed to the government and what taxpayers actually paid to the government) was at 

least $257 billion in 2001, the most recent year available. This is about 13 percent of 

federal revenue. Some experts believe that simplicity and transparency can 

contribute to compliance, as voluntary compliance is likely to increase if taxpayers 

are less likely to make errors on their tax returns and have fewer opportunities to 

evade taxes. 

While federal tax policy changes may alter the amount of revenue collected by the 

federal government these changes can also alter the amount of revenue that state and 

local governments collect. State and local governments collect nearly one-third of all 

the tax revenue generated in the United States each year.

In many cases, state governments link their tax bases to the federal tax base. For 

example, some states use a taxpayer’s adjusted gross income from the federal tax 

return to calculate state income taxes. If the federal government enacted provisions 

that reduce the size of the tax base used to calculate a taxpayer’s adjusted gross 

income, then absent policy changes in the affected states, these state governments 

would likely see a decrease in state tax revenues. Conversely, if the federal 

government reduced the number of tax expenditures, increasing the size of the tax 

base, state governments would likely see an increase in state tax revenues. Thus, 

major changes to the federal tax base could lead to a variety of challenging tax system 

changes at the state level. For example, if the federal government adopted a 

consumption tax base, many states may have to consider whether they wish to 

maintain state income taxes.

General Options Suggested for Fundamental Tax Reform 

Recent years have seen a variety of proposals for fundamental tax reform. These 

proposals would significantly change the tax base, tax rates, and collection points of 

the tax. 

Some of the proposals would replace the federal income tax with some type of 

consumption tax. The retail sales tax, value-added taxes, the personal 

consumption tax, and the flat tax are all types of consumption taxes. They vary in 

their collection points and structure. Similarly, collection points and rate structure 

will vary under an income tax base. 
Section 1: Revenue—Taxes Exist to Fund Government

 22 GAO-05-1009SP 

Text box 2 briefly summarizes the general categories of proposals. 

Key Questions 

1. What current taxes would the proposal change?

• Does the proposal change personal income taxes, social insurance taxes, 

corporate income taxes, and/or estate and gift taxes?

2. What is the nature of the proposed change to the tax system?

• Does the proposal change the tax base from income to consumption?

• Does the proposal include tax expenditures?

• Does the proposal change the tax rates?

• Does the proposal change the collection points for the tax?

3. How will the proposed change affect total revenues?

• Are proposed changes to the tax code likely to be revenue neutral? 

Text Box 2: General Categories of Tax Reform Proposals

In recent years, lawmakers and analysts have suggested a variety of tax reform proposals that would 

change the way in which Americans pay taxes. 

• National retail sales tax (NRST): An NRST would be collected by businesses with, in most cases, no 

need for individuals to file tax returns (some taxpayers may be required to file tax returns in order to 

get back taxes that they paid on items for business use). The base would be retail sales of goods and 

services to final customers. Rates could not vary by individual.

• Value-added taxes (VAT): VATs, now widely used in other countries, are collected by businesses with 

no need for individual tax returns. The VAT taxes all sales to both consumers and other businesses, 

adjusting for purchases from other businesses, which is equivalent to the base of an NRST. Rates do 

not vary by individual. Some experts believe a VAT would be easier to enforce than an NRST.

• Flat tax: A consumption flat tax would have the same base as an NRST or a VAT but would split 

collection between businesses and individuals by making wages deductible by businesses but taxable 

at the individual level. Generally, a single tax rate would apply to both individuals and businesses. 

Because of the individual component of the tax, wages up to some level can be exempted from tax, 

which would introduce some progessivity into this tax system. 

• Personal consumption taxes: A personal consumption tax would look much like the current individual 

income tax. Individuals would report their income from wages, interest, dividends, and so on. It would 

differ in that borrowed funds would be included in the tax base, and funds that are saved or invested 

would be deducted. The base is equivalent to that of other consumption taxes. Rates could vary 

based on individual characteristics.

• Reformed income tax system: Over the years, the Department of the Treasury and others have 

discussed options for reforming the current tax system that would replace the current income tax with 

a more broadly based income tax. For example, proposals have been advanced to integrate the 

personal and corporate income tax and to eliminate preferences on certain types of income, which 

would broaden the tax base and could result in reduced tax rates (if the proposal were revenue 

neutral). 
Section 1: Revenue—Taxes Exist to Fund Government

GAO-05-1009SP 23

• If not, will they generate more or less revenue than the current tax laws? 

4. What effect would the proposal have on the nation’s projected budgets and longterm fiscal outlook? 

• Does the proposal take into consideration the sizable long-term fiscal gap that 

the country faces?

5. What tax expenditures are included in the proposal, and what tax expenditures, if 

any, have been removed from the current tax system?

• Are the social and economic goals of the tax expenditures likely to be achieved 

and worth the cost in lost revenue?

• When the total costs of a program are considered, would it be less costly to 

implement the program as a tax expenditure or as a spending program?

6. If the proposal changes the tax base, the tax rates, or the collection points, how 

would these changes alter the amount of revenue that the government is able to 

collect? 

7. What implications, if any, would the proposal have on the ability of state and local 

governments to collect tax revenues? 

• Would the proposal tax the same base that many states rely on?

• Would the proposal allow many states to continue to rely on the federal tax 

base as a starting point for determining state taxes? 
24 GAO-05-1009SP 

Criteria for a Good Tax System Secotin2

How should a tax system be designed to raise a given amount of revenue? More 

specifically, what criteria should be used to evaluate the advantages and 

disadvantages of a particular tax system, or a particular tax policy proposal? The 

answers matter because various combinations of tax bases and rates can raise the 

same amount of revenue. 

Three long-standing criteria—equity; economic efficiency; and a combination of 

simplicity, transparency, and administrability—are typically used to evaluate tax 

policy. These criteria are often in conflict with each other, and as a result, there are 

usually trade-offs to consider between the criteria when evaluating a particular tax 

proposal. Some of the criteria, such as equity and transparency, are more subjective 

while other aspects of some of the criteria, such as economic efficiency, can be 

defined more objectively. Additionally, people may disagree about the relative 

importance of the criteria. Consequently, citizens and elected officials are likely to 

hold a wide range of opinions about what the ideal tax system should look like. (See 

fig. 9.) 

Figure 9: Trade-offs in the Criteria for Assessing Tax Reform 

Sources: GAO (text); PhotoDisc (images).

 rade-offs between the three criteria listed at the 

 left mean that there is no widely agreed upon 

 optimal tax system. Tax system design is a matter 

 of judgment about how to best balance equity, 

efficiency, and simplicity, transparency, and 

 administrability.

Effici e ncy

Transition effects

• Equity 

• Economic efficiency 

• Simplicity, transparency, 

 and administrability

Criteria for a good tax system:

Revenue

ssues to consider when thinking 

about tax system changes:

I
Section 2: Criteria for a Good Tax System

GAO-05-1009SP 25

In the following sections, we explain these criteria. The fact that a particular tax is 

viewed favorably from the perspective of one of the criteria is not an overall 

endorsement of the tax.
Section 2: Criteria for a Good Tax System

 26 GAO-05-1009SP 

Equity

There are a wide range of opinions regarding what constitutes an equitable, or fair, 

tax system. There are principles—a taxpayer’s ability to pay taxes and who receives 

the benefits from the tax revenue that is collected—that are useful for thinking about 

the equity of the tax system. However, these principles do not change the fact that 

conclusions about whether one tax is more or less equitable than another are value 

judgments. Similarly, analytical tools, such as distributional analysis, while 

providing useful factual information about who pays a tax and how much they pay, do 

not replace individuals’ value judgments about what constitutes a fair tax system. 

(See fig. 10.)

Figure 10: Equity Overview

Equity Principles

Two principles of equity underlie debates about the fairness of different tax policies. 

The ability to pay principle and the benefits received principle do not identify 

one tax policy as more equitable than another, but they can be used to clarify and 

support judgments about equity. When making judgments about the overall equity of 

government policy, it is important to consider both how individuals are taxed and 

how the benefits of government spending are distributed. Even if some judge tax 

 ifferent people have different views about what 

constitutes an equitable tax system. However, by 

developing an understanding of the following issues, 

people may be able to develop a stronger basis for coming 

to conclusions about the equity of the tax system:

Equity principles

• Ability to pay principle

 - Horizontal and

 vertical equity

• Benefits received

 principle

Measuring who pays

• Time period of

 analysis

• Ability to pay measure

• Unit of analysis

• Tax incidence

• Taxes included

• Measures of burden

Sources: GAO (text); PhotoDisc, © Corbis (images).

Transition effects

• Equity 

• Economic efficiency

• Simplicity, transparency, 

 and administrability

Criteria for a good tax system:

Revenue

ssues to consider when thinking 

about tax system changes:

I
Section 2: Criteria for a Good Tax System

GAO-05-1009SP 27

policy to be inequitable, government policy as a whole may be considered more 

equitable once the distribution of both taxes and government benefits is accounted 

for. For the purposes of this report, we have confined our discussion of equity to the 

distribution of tax burdens. 

Ability to Pay Principle

The ability to pay principle states that those who are more capable of bearing the 

burden of taxes should pay more taxes than those with less ability to pay. The ability 

to pay principle relates taxes paid to some measure of ability to pay, such as overall 

wealth, income, or consumption. However, ability to pay may vary depending on the 

measure chosen. For example, a taxpayer’s ability to pay, measured by overall 

wealth, may differ significantly from his or her ability to pay measured by income. A 

taxpayer who worked for many years and then retired may have accumulated a 

significant amount of wealth and may, as a result, have a higher ability to pay taxes 

but may have low current income. 

Some features of the current income tax can be viewed as reflecting attempts to 

account for differences in ability to pay. For example, two taxpayers with the same 

income may not have the same level of economic well-being—the same ability to 

pay—if one has high medical expenses and the other does not. For this reason, the 

current income tax allows deductions for large medical expenses. Other provisions of 

the tax code, such as the deduction for the number of dependents, may also adjust 

income to better reflect ability to pay. Some items that clearly affect ability to pay, 

such as the contribution provided by a nonworking spouse to a family’s well-being, 

are not included in taxable income, in part because of difficulties in valuing these 

aspects of economic well-being. People have different views about the factors that 

affect ability to pay.

Additionally, some do not agree that income is the best measure of ability to pay. As 

noted above, some argue that consumption provides a better measure of a taxpayer’s 

ability to pay taxes than income.

Horizontal and Vertical Equity

The concepts of horizontal equity and vertical equity are refinements of the 

ability to pay principle. 

Horizontal equity requires that taxpayers who have similar ability to pay taxes receive 

similar tax treatment. Targeted tax expenditures, such as deductions and credits, 

could affect horizontal equity throughout the tax system because they may favor 

certain types of economic behavior over others by taxpayers with similar financial 

conditions. For example, two taxpayers with the same income and identical houses 

may be taxed differently if one owns his or her house and the other rents because 

mortgage interest on owner-occupied housing is tax deductible.
Section 2: Criteria for a Good Tax System

 28 GAO-05-1009SP 

Vertical equity deals with differences in ability to pay. Subjective judgments about 

vertical equity are reflected in debates about the overall fairness of the following 

three types of rate structures, where for this example, income is used as the measure 

of ability pay:

• Progressive tax rates: The tax liability as a percentage of income increases as 

income increases. 

• Proportional tax rates: Taxpayers pay the same percentage of income, 

regardless of the size of their income. 

• Regressive tax rates: The tax liability is a smaller percentage of a taxpayer’s 

income as income increases. 

Just because the statutory rate structure for a tax is progressive does not necessarily 

mean that the tax system is progressive overall. For example, when considering an 

individual income tax, if statutory marginal tax rates increase as taxable income 

increases the tax rate structure is progressive. However, as shown in text box 3,

statutory tax rates are not the same as effective tax rates—progressive statutory 

tax rates could be offset by other features of the tax system. Average effective tax 

rates, or the amount of tax that a taxpayer actually pays as a percentage of his or her 

total income (after deductions, credits, and exclusions are removed from the 

equation) may make the tax less progressive if there are a variety of provisions in the 

tax code that reduce the taxable income of wealthier taxpayers. 
Section 2: Criteria for a Good Tax System

GAO-05-1009SP 29

People hold different opinions as to whether the current rate structure is vertically 

equitable. Some believe that the rate structure should be more progressive, and that 

effective tax rates should rise with income more rapidly than they do under the 

current system. Others support a proportional rate structure. They believe that a tax 

system that imposes a single flat tax rate on income is more equitable because each 

additional dollar earned is taxed at the same rate. 

Benefits Received Principle

In contrast to the ability to pay principle, the benefits received principle states that 

the amount of tax paid should be directly related to the benefits that a taxpayer 

receives from the government. In practice, the benefits received principle requires the 

government to identify who benefits from specific government services. As a result, 

the benefits received principle is usually not applicable when considering 

government programs intended to provide societywide benefits or redistribute 

wealth. 

The federal tax on gasoline is an example of a tax that is sometimes justified on the 

benefits received principle. Gas taxes are paid by road users. This means that the 

people who pay the tax (drivers) are the same taxpayers who receive the benefits 

from the revenue collected in the form of both new and improved highways. User 

Text Box 3: Examples of Different Types of Tax Rates 

Conclusions about the overall equity of the tax system may be different depending on which type of tax 

rate one considers.

Statutory tax rates are the tax rates that are defined by law in the tax code and applied to taxable 

income. Effective tax rates differ from statutory tax rates in that they are typically measured using a 

broader definition of income, which includes items excluded under the current tax code in order to 

provide an estimate of what a taxpayer pays in relation to his or her overall total income. 

Marginal tax rates are the rates that taxpayers pay on the next dollar of income that is earned. Marginal 

tax rates can be presented as both marginal statutory rates and marginal effective rates. Average tax 

rates are the total amount of tax a taxpayer pays divided by some measure of his or her income. In the 

current tax system, average tax rates are sometimes presented as the amount of tax a taxpayer pays 

divided by his or her taxable income. Average effective tax rates differ in that they are developed using 

a broader measure of total income than taxable income.

The following tax rates are often discussed when considering the equity of the tax system.

• Marginal statutory tax rates: The tax rate that a taxpayer pays on his or her next dollar of income 

earned as defined by law in the tax code. 

• Marginal effective tax rates: The actual rate of tax that a taxpayer faces on the next dollar of income 

earned when all other provisions of the tax (deductions, credits, etc.) are included. • Average effective tax rates: The overall rate of tax a taxpayer pays as a percentage of his or her total 

income after all other provisions of the tax system (deductions, credits, etc.) are included.

Conclusions about the progressivity of the tax system may differ, for example, depending upon whether 

they are based on an examination of the statutory marginal rate structure or on the effective marginal 

rate structure.
Section 2: Criteria for a Good Tax System

 30 GAO-05-1009SP 

fees, such as postage stamps or fees to enter national parks, are another example of 

taxes based on the benefits received principle. 

Measuring Who Pays: Distributional Analysis

Distributional analysis, which shows tax burden by differing income groups, is used 

to measure how different tax proposals would affect taxpayers with varying ability to 

pay, or the way in which the tax burden is to be shared among various income groups. 

Some tax reform proposals may alter the distribution of taxes paid among various 

groups of taxpayers, while other tax reform proposals may be distributionally neutral, 

or maintain the same distribution of tax burdens as the tax system that is already in 

place. The Tax Reform Act of 1986 is an example of a tax reform proposal that was 

intended to be distributionally neutral.

The distributional analyses of a specific tax proposal may differ for a variety of 

reasons. Among the most important are (1) the time period included in the analysis, 

(2) the manner in which ability to pay is measured, (3) the unit of analysis, 

(4) assumptions regarding tax incidence, (5) the taxes included in the analysis, and 

(6) the measures of tax burden used in the table.

Time period of the analysis: Most distributional analysis tables use annual measures 

of income and taxes, although some use longer periods. However, a 1-year time 

horizon provides a limited perspective on the distributional effects of federal taxes. 

For example, consider the same individual at different points in his or her life. When 

he or she enters the workforce, income and wealth usually are relatively low but 

increase over time when prime earnings years are reached and assets and savings 

begin to be accumulated. With retirement, annual wages fall and savings are the 

primary support for the retirees lifestyle. As a result of fluctuations in income over 

time, annual tables measuring the distribution of tax burdens may group together 

people who have different lifetime economic circumstances.

Ability to pay measure: Most studies that measure distributional effects of 

alternative tax proposals include a broad measure of income that includes more than 

just taxable income to measure a taxpayer’s ability to pay. Some types of nonwage 

income, such as investment income, are relatively easy to identify and include in 

distributional tables, while others are more difficult. For example, distributional 

analyses may attempt to adjust for such factors as the value of employer-provided 

fringe benefits in order to broaden the definition of income to better reflect ability to 

pay. 

However, while income is the most commonly used measure of ability to pay in 

distributional analysis, other measures of ability to pay, such as consumption, may 

also be used to create distributional tables. As we mentioned earlier, some believe 

that consumption is a better measure of ability to pay taxes than income.
Section 2: Criteria for a Good Tax System

GAO-05-1009SP 31

Unit of analysis: The unit of analysis used to group taxpayers together may also 

affect the outcome of distributional tables. Some analysts create distributional tables 

using individual taxpayers as the unit of analysis, while others group taxpaying units 

(people included on a tax return, families, or households) together. Distributional 

tables may differ if one table uses individual taxpayers and another table uses a 

taxpaying unit because a taxpaying unit may include more than one individual who 

pays taxes. 

Tax incidence: The actual burden of a tax does not always fall on the people or 

businesses that actually pay the tax to the government, and assumptions about tax 

incidence may affect the results of distributional tables. The statutory incidence of 

a tax—the parties who are legally required to pay the tax—may not be the same as its 

economic incidence—the parties who actually bear the burden of the tax—because 

taxpayers who legally must pay the tax can sometimes shift the burden to others 

through changes in prices, wages, and returns on investments. For example, from a 

statutory perspective, the employee and employer contribution to the payroll tax are 

equal. However, most analysts agree that employees bear the entire burden of the 

payroll tax in the form of reduced wages. 

Determining who bears the burden of the corporate income tax is an example of how 

difficult it can be to determine the incidence of a tax. Text box 4 illustrates some of 

the issues associated with identifying the incidence of the corporate income tax.

Taxes included in the analysis: Some distributional tables include different taxes in 

the analysis, so when comparing two distribution tables, identifying which taxes are 

included in the analysis is necessary to ensure that a valid comparison can be made 

between the two estimates. For example, in table 3, one side of the table includes all 

federal taxes, while the other side only includes the federal income tax. Because it is 

often difficult to isolate the incidence of some taxes, analysts sometimes exclude 

those taxes from the analysis. 

Text Box 4: Incidence of the Corporate Income Tax

Corporations do not actually bear the ultimate burden of the corporate income tax; instead, individuals 

bear the burden of the corporate income tax. A corporation writes a check to the U.S. Treasury to pay 

its tax liability, but the burden of the tax is shifted to other groups of people through lower incomes or 

higher prices. 

The money to pay the tax must come from reduced returns to investors in the corporation, lower wages 

to the company’s employees, or higher prices that consumers pay for the company’s products. In the 

short term, the incidence of the corporate income tax is likely to fall on stockholders or investors in 

general. However, because corporate income taxes may lead to reduced capital investment, in the 

longer term some of the burden of the corporate income tax is more likely shifted to people who earn 

income from labor. Reduced capital investment can lead to lower productivity and, consequently, lower 

wages.

Due to the difficulty of identifying the incidence of the corporate income tax, some, including the Joint 

Committee on Taxation, often exclude the corporate income tax from distributional tables altogether. 
Section 2: Criteria for a Good Tax System

 32 GAO-05-1009SP 

Measures of tax burden: Distributional tables may also produce different results 

based on the measures of tax burden that are used. Effective tax rates and share of 

tax liability (portion of total taxes that households in each quintile collectively 

remitted to the government), the measures used in table 3, are two common measures 

of tax burden. Some distributional tables show how effective tax rates would change 

if the tax code were changed. 

Different Assumptions Lead to Different Distributional Analyses

The Office of Tax Analysis in the Treasury Department, the Congressional Budget 

Office (CBO), and the Joint Committee on Taxation are the three government sources 

of tax distributional analysis, and their distributional tables may differ based on the 

assumptions that they make about the issues we have outlined above.

The example in table 3, which shows two measures of tax burden, illustrates the fact 

that making different assumptions when conducting distributional analysis can lead 

to different results. 

Table 3: Measures of Tax Burden: Distribution of Total Federal Taxes and Individual Income Taxes 

in 2004 

Source: Congressional Budget Office, Effective Federal Tax Rates Under Current Law, 2001 to 2014 (Washington, D.C.: August 2004). 

Note: In table 3, numbers do not always add due to rounding.

Both of the distribution tables were prepared by CBO using the same methodology to 

measure the distributional effects of the tax system in 2004 using 2001 income 

(adjusted for inflation and nominal income growth to reflect income in 2004) as the 

base for the analysis. The only difference between the left side of the table and the 

right side of the table is the taxes that are included in the analysis. The left side 

includes total federal taxes, excluding estate and gift taxes and several other 

miscellaneous sources of revenue, while the right side of the table only includes 

individual income taxes. The table that presents total federal taxes uses the 

assumption that individuals bear the burden of the employee and employer share of 

Total federal taxes Individual income taxes

Income quintiles

Average 

effective tax 

rates

Share of tax 

liability

Average 

effective tax 

rates

Share of tax 

liability

Lowest quintile 5.2% 1.1% -5.7% -2.7%

Second quintile 11.1% 5.2% -0.1% -0.1%

Middle quintile 14.6% 10.5% 3.5% 5.4%

Fourth quintile 18.5% 19.5% 6.6% 15.2%

Highest quintile 23.8% 63.5% 14.2% 82.1%

All 19.6% 100.0% 9.0% 100.0%
Section 2: Criteria for a Good Tax System

GAO-05-1009SP 33

payroll taxes, and owners of capital income bear the burden of the corporate income 

tax. The effective tax rates for individual income taxes are negative for the two 

lowest income quintiles because the table includes some offsets to tax liability, such 

as the earned income tax credit.

Key Questions

1. How is a taxpayer’s ability to pay broadly defined: 

• Income?

• Consumption?

• A broader definition of overall wealth? 

2. What factors other than income, such as medical expenses, number of 

dependents, and so forth, does the proposal account for when considering a 

taxpayer’s ability to pay taxes?

3. Will taxpayers with equal ability to pay taxes pay the same amount?

• If not, what provisions of the proposal do not adhere to the principle of 

horizontal equity? 

4. How will the tax system tax people with differing ability to pay?

• Are the statutory tax rates progressive, proportional, or regressive?

• Are the average effective tax rates progressive, proportional, or regressive 

(accounting for credits, deductions, and other tax expenditures)?

5. Are there any components of the tax proposal that are justified on the benefits 

received principle? 

• If so, what mechanisms are in place to determine that taxpayers who pay taxes 

for a particular government program are the same taxpayers who benefit from 

the provisions of that program?

6. Does the proposal maintain the distribution of taxes (i.e., is the proposal 

distributionally neutral)?

• If not, who will be paying more in taxes and who will be paying less?

• If so, what features of the proposal are in place to ensure that it will remain 

distributionally neutral?

7. What type of distributional analysis was done?
Section 2: Criteria for a Good Tax System

 34 GAO-05-1009SP 

• What time period is covered? For example, does the distributional analysis 

measure the lifetime or annual effects of the tax system?

• How is ability to pay (income, consumption, or wealth) measured?

• What is the unit of analysis (individuals, households, or taxpaying units)?

• What assumptions are made about tax incidence (e.g., who is assumed to pay 

the corporate income tax)?

• What taxes are covered in the distributional analyses? 

• What measures (e.g., tax rates, share of tax liability) are being used to calculate 

the distribution of tax burden? 
Section 2: Criteria for a Good Tax System

GAO-05-1009SP 35

Economic Efficiency 

One reason people bear taxes is they desire the benefits of government programs and 

services. As taxpayers, they balance the costs of taxes with the benefits of 

government. From a taxpayer’s perspective, the cost of taxes includes more than the 

tax liability paid to the government. These costs include efficiency costs, which result 

from taxes changing the economic decisions that people make—decisions such as 

how much to work, how much to save, what to consume, and where to invest. These 

changes, referred to by economists as distortions, reduce people’s well-being in a 

variety of ways that can include a loss of output or consumption opportunities. These 

reductions in well-being are efficiency costs, also called deadweight losses, excess 

burdens (excess because they are a cost in addition to the tax liability), or welfare 

losses. 

Because taxes generally create inefficiencies, minimizing efficiency costs is one 

criterion for a good tax. However, the goal of tax policy is not to eliminate efficiency 

costs. The fact that taxes impose efficiency and other costs beyond the tax liability 

does not mean that taxes are not worth paying. The goal of tax policy is to design a 

tax system that produces the desired amount of revenue and balances economic 

efficiency with other objectives, such as equity, simplicity, transparency, and 

administrability. Moreover, as noted in the revenue section, the failure to provide 

sufficient tax revenues to finance the level of spending we choose as a nation gives 

rise to deficits and debt. Large sustained deficits could ultimately have a negative 

impact on economic growth and productivity.

Because taxes impose efficiency costs, the total cost of taxes to taxpayers is larger 

than their tax liability (the check they send to the U.S. Treasury). The total cost of 

taxes from a taxpayer’s point of view is the sum of the tax liability, the efficiency 

costs, and the costs of complying with the system (which we discuss later), as shown 

in figure 11. 
Section 2: Criteria for a Good Tax System

 36 GAO-05-1009SP 

Figure 11: Efficiency Costs Are One Cost Taxpayers Face in Complying with the Tax System

From a national perspective tax revenue is not a cost. Tax revenue is not lost to the 

nation—it is moved from taxpayers’ pockets to the Treasury in order to pay for the 

programs and services that the government provides. On the other hand, efficiency 

costs and compliance burden are costs from a national perspective because, for 

example, they can result in forgone production and consumption opportunities, as 

well as the loss of taxpayers’ time spent on complying.

Tax systems can differ in the magnitude and nature of their efficiency costs. 

Differences in the base, rates, preferences, or tax-induced responses can all affect the 

extent one tax distorts when compared to another. Tax systems can cause distortions 

that affect both individual taxpayers and businesses. Figure 12 outlines some of the 

key issues to consider when thinking about the efficiency of the tax system.

Source: GAO.

Tax liability

Total cost of 

a tax to

a taxpayer

Efficiency 

cost

 Compliance

burden + + =

In addition to the tax revenue collected and the compliance burden of taxation, taxes 

generate efficiency costs that reduce people’s well-being. For example, these efficiency 

costs can come in the form of lost output or consumption opportunities.
Section 2: Criteria for a Good Tax System

GAO-05-1009SP 37

Figure 12: Efficiency Overview 

Equity concerns may force a trade-off between fairness and efficiency. Progressive 

tax rate schedules are believed to have higher efficiency costs than a proportional 

schedule that raises the same amount of revenue. However, proponents of 

progressive rates are willing to trade off some efficiency in order to gain, in their 

view, more vertical equity. As will be shown below, efficiency costs, although they are 

hard to measure, often can be defined objectively. Nevertheless, they still must be 

balanced with the more subjective criteria like equity when reaching general 

conclusions about a tax proposal.

Taxes and Economic Decision Making

Economic efficiency can be thought of as the effectiveness with which an economy 

utilizes its resources to satisfy people’s preferences. Economists generally agree that 

(from the perspective of efficiency and ignoring other considerations, such as equity) 

markets are often the best method for determining what goods and services should be 

produced and how resources should be allocated. Self-interest is assumed to 

motivate resource owners to try to use their resources in a manner that realizes the 

highest return. When resources are directed to their highest valued uses the economy 

is said to be efficient. 

Sources: GAO (text); PhotoDisc (image).

Taxes and economic decision making

Measuring economic efficiency

Taxing work and savings decisions 

• Work versus leisure

• Savings versus consumption

• Domestic versus foreign investment

• Efficiency and economic growth

• Efficiency versus fiscal effects

Realizing efficiency gains

 n efficient tax system would not distort economic 

decisions. Tax-induced distortion of decisions to work, 

consume, and invest can reduce well-being. When thinking 

about economic efficiency, it may be helpful to consider 

the following issues:

Transition effects

• Equity

• Economic efficiency

• Simplicity, transparency, 

 and administrability

Criteria for a good tax system:

Revenue 

ssues to consider when thinking 

about tax system changes:

I
Section 2: Criteria for a Good Tax System

 38 GAO-05-1009SP 

Inefficiencies reduce the economic well-being of people in the aggregate, since 

resources are not directed to their highest valued uses. By reallocating resources 

from lower valued uses to higher valued uses, the economic well-being of people can 

be increased. However, gains from reallocating resources from lower valued uses to 

higher valued uses may not be distributed in manner considered fair, that is, some 

people may lose because of the reallocation.

Generally, taxes alter or distort decisions about how to use resources, creating 

economic inefficiencies. By changing the relative attractiveness of highly taxed and 

lightly taxed activities, taxes distort decisions such as what to consume, how much to 

work, and how to invest. Households and firms generally respond to taxes by 

choosing more of lower taxed items and less of higher taxed items than they would 

have otherwise. The change in behavior can ultimately leave individuals with a 

combination of consumption and leisure that they value less than the combination 

that they would have chosen under a tax system that does not distort their behavior. 

As a simple example of the effects of a tax distortion, suppose an investor is choosing 

between two investments, one that has an expected annual return of 10 cents on 

every dollar invested and a second that has an expected annual return of 15 cents. If 

the income from neither investment is taxed, or if the income is taxed equally, the 

investor will choose the second investment with its higher economic rate of return. 

However, if the first investment continues to be untaxed, while the second is subject 

to a 40 percent tax, the decision will be based on the investment’s after-tax rate of 

return. In this case the after-tax return on the first investment continues to be 10 

cents for every dollar invested, while the after-tax return on the second investment is 

now 9 cents. An investor would choose the first investment because it has a higher 

after-tax return. However, this results in a loss to the economy, or inefficiency. 

Society gains a 10 cent return from the first investment, all of which goes to the 

investor. Society would have gotten the 15 cent return from the second investment, 9 

cents for the investor, and 6 cents for the government.

Note that a tax does not actually have to raise revenue to cause inefficiencies. In the 

previous example, the investor who chose the first investment would pay no tax. 

However, the tax system design has distorted the investor’s decision-making and 

reduced output.

The example of the tax-preferred treatment of owner-occupied housing illustrates a 

trade-off between efficiency costs and using the tax system to achieve other social 

goals. Text box 5 presents some estimates of the efficiency costs of the tax treatment 

of owner-occupied housing due to large differences in effective tax rates across three 

major investment categories. However, even in situations such as the one outlined in 

the text box, where the tax preference imposes some efficiency costs, there may still 

be valid reasons for using tax preferences as a tool of government for achieving 

certain social and economic goals. As we note in the example, most economists agree 

that the tax-preferred treatment of owner-occupied housing distorts investment 
Section 2: Criteria for a Good Tax System

GAO-05-1009SP 39

patterns in the economy. The tax preference promotes the social goal of increased 

home ownership—a goal that many policymakers advocate. 

Although taxes generally result in efficiency losses, there are exceptions. In special 

cases, tax distortions may offset other inefficiencies, which can be caused by what 

economists call market failures. An example is an externality or spillover, where 

the benefits or costs of an activity are not fully captured by the individuals or firms 

undertaking the activity. Research and development is commonly cited as generating 

positive externalities—in some cases, the entity doing the research and development 

may produce knowledge that enters the public realm and is freely available to users. 

For example, some medical innovations, such as surgical techniques, cannot be 

patented. To the extent that benefits cannot be sold in a market, private firms that 

innovate will not reap the full financial benefits of the innovation and, therefore, will 

invest too little in research. Tax incentives for research might be one way to address 

the problem, but other governmental tools such as grants, loans, or regulations could 

also be considered. Efficient taxes are special cases—tax systems large enough to 

fund the federal government impose efficiency costs. 

Text Box 5: Tax Treatment of Owner-Occupied Housing Distorts Investment Choices and Lowers 

Wages

Compared to other types of investment, owner-occupied housing enjoys tax advantages primarily 

because the value that homeowners receive from housing services, which is a part of the return on 

their investment in housing, is excluded from taxation. Economists view these services, called imputed 

rent, as income in kind, which is valued at what the homeowner would receive as income if the house 

was rented. Under a pure income tax, imputed rent net of such costs as mortgage interest would be 

taxed. This tax treatment would help insure that investment in housing is taxed as other investments 

are taxed. As the table below shows, the tax advantages under the current system lead to lower 

marginal effective tax rates (METR) for housing relative to other investments.

METRs on Capital Income, by Source, in 2003

• Owner-occupied housing 2%

• Noncorporate investment 18%

• Corporate investment 32%

Source: Jane Gravelle, “The Corporate Tax: Where Has It Been and Where Is It Going?” National Tax 

Journal, vol. 57, no. 4 (2004): 903-23

Economists generally agree that the favorable treatment of owner-occupied housing, by lowering 

METR, distorts investment in the economy, resulting in too much investment in housing and too little 

business investment. The consequence of this is that businesses invest less in productivity-enhancing 

technology. This in turn results in employees receiving lower wages because increases in employee 

wages are generally tied to increases in productivity.

The resulting distortions from the tax-preferred treatment of owner-occupied housing lead to efficiency 

costs that have been estimated to be large. Gravelle’s summary of estimates reports that the efficiency 

costs of the tax-preferred treatment of owner-occupied housing could be as much as 0.1 to 1 percent of 

GDP.

In addition to efficiency concerns, the tax treatment of owner-occupied housing also raises equity 

concerns. The current exclusions from income are more valuable to taxpayers in high tax brackets. 

Taxpayers in lower brackets receive a less valuable homeownership subsidy or no subsidy at all.
Section 2: Criteria for a Good Tax System

 40 GAO-05-1009SP 

Measuring Economic Efficiency

While economists generally agree that the tax system imposes significant efficiency 

costs, estimating the magnitude of tax-related efficiency costs in an economy as 

complex as ours is extremely difficult. However, several attempts have been made to 

estimate the efficiency costs of parts of the tax system. For example, one study 

estimated the total efficiency cost of the personal income tax on labor income, which 

distorts labor supply decisions, to be from $137 billion to $363 billion in 1994.3

 A 

second study estimated the effects of the unequal taxation of savings and 

consumption to be about $45 billion in 1995.4

 Text box 5 summarized estimates of the 

efficiency losses associated with the tax treatment of owner-occupied housing as 

ranging from 0.1 to 1 percent of GDP. For further information on efficiency cost 

estimates, see GAO, Tax Policy: Summary of Estimates of the Costs of the Federal 

Tax System, GAO-05-878 (forthcoming).

These partial estimates indicate the significant uncertainty surrounding the 

magnitude of tax-induced efficiency costs. Nevertheless, they suggest that the overall 

efficiency costs imposed by the tax system are large—on the order of several 

percentage points of GDP. 

As a result of these difficulties, simple rules of thumb are commonly used to provide 

rough estimates of the efficiency costs of taxes. Text box 6 describes two such rules 

of thumb.

3

Martin Feldstein, “Tax Avoidance and the Deadweight Loss of the Income Tax,” The Review of Economics 

and Statistics, vol. 81, no. 4 (1999).

4

Jinyong Cai and Jagadeesh Gokhale, “The Welfare Loss From a Capital Income Tax,” Federal Reserve 

Bank of Cleveland Economic Review, vol. 33, no. 1 (1997).

Text Box 6:Rules of Thumb for Estimating Efficiency Costs

Because of the difficulty of measuring efficiency costs, several rules of thumb have been used to 

approximate efficiency costs in certain situations. These rules suggest that efficiency costs from taxes 

may be considerable.

Two commonly cited rules are as follows:

• According to OMB guidance, the efficiency cost of a tax increase, which should be included as 

part of the total cost when calculating the benefits and costs of a government spending project, 

is equal to 25 percent of the tax revenue collected used to fund the project.

• Some economists agree that the efficiency cost of a tax increases with the square of the tax 

rate: a 50 percent tax increase, for example, from 25 percent 37.5 percent, would more than 

double the efficiency cost. For this reason, progressive tax rate schedules, which have higher 

top marginal rates, are believed to have higher efficiency costs than a proportional schedule that 

raises the same amount of revenue. 
Section 2: Criteria for a Good Tax System

GAO-05-1009SP 41

The extent to which tax reform can reduce such tax-induced inefficiencies and thus 

increase our economic well-being depends on the design of a reformed system. All 

practical tax systems distort some decisions so it is not possible to eliminate all the 

efficiency costs associated with taxes. The magnitude of the efficiency costs in a 

reformed tax system would depend on such design features as the treatment of 

savings versus consumption, the number of tax expenditures, and the level and 

progressivity of tax rates. While some economists believe that a pure consumption 

tax with no preferences and a flat rate would reduce efficiency costs relative to the 

current tax system, such a pure tax may not be a feasible alternative because of 

equity and other concerns.

In addition, as has been discussed, the revenue consequences of tax reform have 

economic effects. The efficiency gains from a reformed tax system could be offset if 

the new system increases long-term deficits. 

Taxing Work and Savings Decisions 

In part because of the difficulty of measuring the efficiency cost of taxes, discussions 

of the impact of taxes on the economy sometimes focus on the effect that taxes have 

on changes in the output of the economy, labor supply, or other such economic 

variables. However, such changes do not necessarily measure efficiency costs. 

Efficiency loss is the difference between individuals’ well-being with a tax and 

individuals’ well-being under a revenue neutral, hypothetical tax that does not distort, 

called a lump sum tax. 

Three choices commonly discussed are the choice between work and leisure, the 

choice between consumption and saving, and the choice between domestic and 

foreign investment. Intertwined with effects that taxes have on these choices is the 

effect of taxes on economic growth.

Work versus leisure: Taxes—both income and consumption taxes—can affect the 

decisions that people make about how much time to devote to work or leisure in two 

ways. First, taxes may increase the incentive to work because workers must work 

more to maintain their after tax income. Second, taxes may reduce the incentive to 

work because workers earn less from an additional hour of work. The net effect may 

be no change to the overall supply of labor. However, even in this case, there is still an 

efficiency cost, which is determined by the second effect. By reducing hourly after 

tax earnings, income and consumption taxes distort decisions about how many hours 

to devote to work or leisure. 

Empirical research generally shows that at least for primary wage earners, decisions 

about labor force participation are not very responsive to taxes. However, decisions 

about labor force participation by secondary wage earners have been shown to be 

more responsive to changes in the tax system.
Section 2: Criteria for a Good Tax System

 42 GAO-05-1009SP 

Consumption versus savings: Taxes on capital reduce the after-tax return to savings. 

In effect, this makes future consumption (savings) more expensive relative to current 

consumption and thus has the potential to distort savings decisions. While research 

has shown that the demand for some types of savings, such as the demand for taxexempt bonds, is responsive to changes in the tax system, there is greater 

uncertainty about the effects of changes in the tax system on other choices, such as 

aggregate savings.

Domestic versus foreign investment: Taxes on income from capital can affect the 

location of investment by changing the relative after-tax return on domestic and 

foreign investment. This matters because the location of investment can affect the 

income of U.S. citizens. The income of people working in the United States is closely 

tied to their productivity, which generally increases with the amount of domestic 

investment. At the same time, U.S. citizens who own capital can earn higher incomes 

by investing their capital—in the United States or abroad—wherever it earns the 

highest rate of return. In a world of increasing capital mobility due to increasing trade 

and decreasing communication and transportation costs, the effect of taxes on the 

location of investment is even more important than in the past 

Efficiency and economic growth: Removing or reducing distortions caused by the 

tax system can affect the size of the economy. Increasing the efficiency of the tax 

system can expand the economy through a temporary increase in the rate of growth. 

An increase in efficiency is an increase in well-being that comes from using existing 

resources in a better way. Efficiency raises capacity to a higher level but does not 

necessarily continue to increase it without additional resources. Such an increase 

could show up as a temporary increase in the growth of the economy. However, the 

long-term growth rate depends on the rates of change in population, the capital stock, 

and technology. Changes to the tax system that would increase economic efficiency 

could increase the long-term growth rate if they increase the rate of technological 

change. Thus, tax changes that increase economic efficiency may or may not result in 

an increased long-term rate of economic growth. 

Efficiency versus fiscal effects: As has been discussed, taxes may have both 

efficiency effects and fiscal policy effects. Government spending in excess of 

government revenues creates deficits, which if large enough and continued over a 

period of time will ultimately have a negative impact on economic growth and 

productivity to the extent that they absorb savings that would otherwise finance 

investment in the private economy. Thus, the gain from changing the tax system to 

increase economic efficiency could be offset if the tax changes increase the deficit.

Tax policies designed to enhance economic efficiency can be designed independently 

of fiscal policy. For example, the Tax Reform Act of 1986 was designed, in part, to 

achieve increased efficiency by broadening the tax base and lowering rates in a way 

that was revenue neutral. Such a revenue neutral change would have no effect on 

deficits and debt. 
Section 2: Criteria for a Good Tax System

GAO-05-1009SP 43

Realizing Efficiency Gains

The extent to which efficiency gains are realized by switching to an alternative tax 

system depends on at least two factors. First, the efficiency gains of switching to a 

new tax system depend on the extent to which that tax system reduces distortions 

caused by tax preferences, rate differences, sectoral differences, and switching the 

base from income to consumption. Second, the change to a new tax system may not 

improve the overall efficiency of the economy if the distorting tax incentives 

eliminated by switching to a new tax system are replaced with government spending 

or regulation that provides the same incentives. 

Key Questions

1. Does the proposal tax income, spending, assets, and investments differentially?

• Which types of income, spending, assets, and investments are tax preferred?

• Which decisions are likely to be distorted?

2. What social goals, if any, is the tax proposal trying to promote? 

• Is there an efficiency justification for the goal, or is the goal justified on other 

grounds, such as equity?

3. Do estimates of the cost of achieving the goal include efficiency costs?

4. What are the trade-offs between equity, efficiency, and the other criteria? 

5. Is the tax proposal accompanied by estimates of the efficiency gains or losses to 

be realized by the new tax system? 

• Is the tax proposal accompanied by estimates of economic activity (e.g., 

change in labor supply or change in GDP) that will be encouraged or 

discouraged by the new tax system?

• Is the proposal accompanied by estimates of the efficiency loss or gain 

associated with these changes in economic activity?

6. How does the tax change affect leisure versus work decisions?

7. How does the tax change affect savings versus consumption decisions?

8. How does the tax change affect decisions about foreign versus domestic 

investment?
Section 2: Criteria for a Good Tax System

 44 GAO-05-1009SP 

9. How does the tax change affect choices between different types of investments 

and different types of consumption? 

10. Is the tax proposal likely to increase economic growth? 

• Is the growth achieved through a onetime rearranging of resources? 

• Is the growth achieved through a permanent increase in the rate of growth?

• Does the tax proposal contain estimates of its effect on growth (often 

measured by changes in GDP) and estimates of the costs of achieving the 

growth (such as reduced leisure time)?

11. In addition to efficiency effects, will the proposal have other economic effects by 

increasing or reducing the deficit?
Section 2: Criteria for a Good Tax System

GAO-05-1009SP 45

Simplicity, Transparency, and Administrability

Simplicity, transparency, and administrability are interrelated and desirable features 

of a tax system. Simple tax systems are, in many cases, the most administrable, and 

tax systems that are both simple and administrable are often considered to be the 

most transparent. However, even though there is considerable overlap between 

simplicity, transparency, and administrability, they are not identical. (See fig. 13.)

Because there is considerable overlap between these concepts, even though they are 

not the same thing, we combine simplicity, transparency, and administrability into 

one section and discuss them as a group. While others may not use the same 

terminology, the debates implicitly use the same or very similar criteria.

Figure 13: Simplicity, Transparency, and Administrability Overview

Simplicity

Simple tax systems impose less of a compliance burden on the taxpayer than more 

complex systems. Taxpayer compliance burden is the value of the taxpayer’s own 

time and resources, along with any out-of-pocket costs to paid tax preparers and 

other tax advisors, invested to ensure compliance with tax laws. As figure 14 

demonstrates, in addition to the actual tax payments remitted to the government and 

Sources: GAO (text); PhotoDisc (images).

Simplicity

• Compliance burden 

 (record keeping, 

 planning, return 

 preparation, and 

 responding to audits)

Transparency

• Of tax calculations

• Of logic behind tax laws

• Of tax burden

• Of compliance

Administrability

• Processing returns

• Enforcement

Transition effects • Taxpayer assistance

• Equity 

• Economic efficiency

• Simplicity, transparency, 

 and administrability

Criteria for a good tax system:

Revenue 

ssues to consider when thinking 

about tax system changes:

I implicity, transparency, and administrability are 

interrelated features of a tax system, but they are not 

the same thing. Issues to consider when thinking about 

the simplicity, transparency, and administrability of the 

tax system include:
Section 2: Criteria for a Good Tax System

 46 GAO-05-1009SP 

the efficiency costs of taxation that we discussed earlier, compliance burden is the 

third cost that the tax system imposes on taxpayers. Compliance costs include the 

value of time and resources devoted to (1) record keeping, (2) learning about 

requirements and planning, (3) preparing and filing tax returns, and (4) responding to 

IRS notices and audits. Taxpayers can either choose to fulfill these responsibilities on 

their own or they can hire paid preparers to aid them in complying with the tax code. 

According to IRS, over 61 percent of returns filed in 2003 included a paid preparer’s 

signature, contributing to considerable out-of-pocket costs to taxpayers.

Figure 14: Compliance Burden Is One Cost Taxpayers Face in Complying with the Tax System

The current tax system has grown increasingly complex over time, and many believe 

that taxpayer compliance burden has grown accordingly. The amount of time that 

taxpayers actually spend filling out tax forms may only constitute a small amount of 

the overall compliance burden. For many taxpayers, the bulk of the compliance 

burden comes in the form of tax planning and record keeping. For example, 

taxpayers spend time determining how the growing number of tax expenditures will 

affect their respective tax liabilities. The Treasury Department listed 146 tax 

expenditures in 2004, up about 26 percent since the last major tax reform legislation 

in 1986. Frequent changes in the tax code reduce its stability, contributing to 

compliance burden by making tax planning more difficult and increasing uncertainty 

about future tax liabilities. Moreover, an increasing number of taxpayers are 

becoming subject to the individual AMT. Determining how the provisions of the AMT 

affect a taxpayer’s tax liability adds to the compliance burden.

Compliance burden is difficult to measure in part because it is difficult to measure the 

amount of time taxpayers spend planning and preparing their returns and the value

Source: GAO.

Tax liability

Total cost of 

a tax to

a taxpayer

Efficiency 

cost

 Compliance

burden + + =

The compliance burden, or the time and resources required to comply with the tax laws– 

including out-of-pocket costs, are a third type of cost that taxes impose on taxpayers. 
Section 2: Criteria for a Good Tax System

GAO-05-1009SP 47

of that time.5 Nevertheless, researchers have made several attempts to quantify the 

costs that taxpayers incur while complying with the tax system. Most estimates 

suggest that taxpayer compliance burden falls between $100 billion and $200 billion 

each year. 

Because compliance burden is difficult to measure, other, less direct measures of 

burden are frequently used. These include the number of pages in the tax code, the 

number of IRS forms to fill out, the length of tax instructions, and the number of lines 

on the tax form. These measures are believed to be correlated with compliance 

burden, but the correlation is recognized to be far from perfect. In some situations, 

longer instructions and more details on a form may reduce compliance burden by 

clarifying what a taxpayer must do to comply with the tax laws. These alternative 

measures of simplicity may provide some insight into the simplicity of the tax code, 

but they do not directly measure the impact that the tax code has on the costs to 

taxpayers of complying with the nation’s tax laws.

The intergovernmental effects of tax policy changes can also affect compliance 

burden. Due to the close links between the federal tax system and the tax systems in 

many states, changes to the federal tax system could have implications for the 

compliance burden that taxpayers face when completing their state tax returns. For 

example, if the federal government switched from the current income tax system to a 

national retail sales tax, or a different type of consumption tax, but states—most of 

which have developed income tax forms that are based in large part on an individual’s 

federal tax return—maintain their income tax requirements, then overall taxpayer 

burden would not likely be greatly reduced. Taxpayers might not have to file federal 

tax returns, but many, if not all, of the record keeping and administrative tasks would 

still exist when complying with the state-level income tax requirements.

Transparency

A transparent tax system is one that taxpayers are able to understand. Transparent 

tax systems impose less uncertainty on taxpayers, allowing them to better plan their 

decisions about employment, investment, and consumption. This leads to more 

confidence that they can accurately predict their future tax liabilities and contributes 

to the credibility of the tax system. Tax systems that are difficult to comply with and 

administer may lack transparency. A nontransparent tax system could be difficult to 

administer because tax administrators may have difficulty consistently applying the 

law to taxpayers in similar situations. In this sense, transparency is closely linked to 

5

It is difficult to measure the amount of time that taxpayers spend planning and preparing their returns 

because, among other reasons, when surveyed, taxpayers may overstate or understate the amount of time 

that they spent depending on how straightforward or complicated their returns were (i.e., how frustrating 

the experience was). Additionally, there is no consensus among researchers regarding the appropriate 

monetary value to be assigned to each hour of time spent on tax compliance activities.
Section 2: Criteria for a Good Tax System

 48 GAO-05-1009SP 

the simplicity and administrability of the tax system. Transparent tax systems 

include the following elements:

• Taxpayers can easily calculate their liabilities: Taxpayers can easily follow 

instructions and tax rate tables in order to determine their tax base, their marginal 

tax rate, and their tax liability to the government. 

• Taxpayers grasp the logic behind tax laws and tax rates: Taxpayers can look at 

a tax form or a tax rate schedule and understand lawmakers’ reasoning. For 

example, whether or not they agree with it, taxpayers are likely to be able to 

comprehend the logic behind a progressive rate schedule.

• Taxpayers know their own tax burden and the tax burden of others: Irrespective 

of who actually writes a check to the government, taxpayers can identify who 

actually bears the burden of a tax. For example, the payroll tax is not transparent 

to the extent that taxpayers in general are unaware of the incidence of the tax. 

Even though payroll taxes are divided equally between employees and employers, 

economists generally agree that employees bear the entire burden of payroll taxes 

in the form of reduced wages. 

• Taxpayers are aware of the extent of compliance by others: Taxpayers 

understand the extent to which the tax laws are enforced, meaning that they know 

how likely their friends, neighbors, and business competitors are to actually pay 

what they owe.

While the concept of transparency is closely linked to simplicity and administrability, 

they are not always the same. For example, some tax provisions may be simple but 

not transparent. The corporate tax rate schedule example in table 4 illustrates this. 

While determining taxable income under the corporate income tax is often a complex 

procedure, it is relatively simple for corporations to calculate their tax liabilities by 

referring to tax tables published by the IRS once this income has been determined. 

However, the logic underlying the marginal tax rates in the corporate tax schedule is 

not transparent. The marginal rate structure is progressive up to taxable income of 

$335,000, but marginal rates then decrease before increasing again and then 

decreasing once more.
Section 2: Criteria for a Good Tax System

GAO-05-1009SP 49

Table 4: The Corporate Tax Rate Schedule: Simple but Not Transparent

Source: IRS instructions for Form 1120.

Some experts who have written on transparency believe that the tax code’s 

transparency has declined in recent years. Numerous tax provisions have made it 

more difficult for taxpayers to understand how their tax liability is calculated, the 

logic behind the tax laws, and what other taxpayers are required to pay. 

Administrability

Administrable tax systems allow the government to collect taxes as cost effectively as 

possible. Even though tax administration is usually considered to be IRS’s 

responsibility, taxpayers, employers, and financial intermediaries such as banks and 

tax professionals play important roles in administering the tax code. For example, 

under the current system, banks file information returns about the amount of interest 

earned by deposit holders that assist IRS in determining tax liabilities. There is 

overlap between the simplicity and the administrability of a tax system, but simple 

tax systems are not always easier to administer. 

Comparing the Administrability of Tax Systems

All tax systems have administrative costs. A more administrable tax system collects 

more of the statutorily required tax at a lower cost per dollar collected. However, 

there are trade-offs between the level of compliance and administrative costs to IRS. 

The costs of enforcing the tax code sufficiently to achieve complete compliance from 

all taxpayers are likely to be prohibitive. In addition, the costs of administrating the 

tax code are not limited to the budgetary costs of IRS. As noted above, some of these 

costs are shared by other parties in the form of increased compliance burden. Finally, 

the costs can be affected by the use of different enforcement policies. 

The following summarizes the key tasks required for administering tax systems: 

Tax bracket 

(taxable corporate income)

Marginal tax rate in the

tax bracket

$0 to $50,000 15%

$50,001 to $75,000 25%

$75,001 to $100,000 34%

$100,001 to $335,000 39%

$335,001 to $10,000,000 34%

$10,000,001 to $15,000,000 35%

$15,000,001 to $18,333,333 38%

Over $18,333,333 35%
Section 2: Criteria for a Good Tax System

 50 GAO-05-1009SP 

• Processing tax returns and payments: Currently, IRS processes over 130 million 

individual income tax returns each year, which taxpayers file electronically or 

through the mail. Under today’s technology and any proposed alternatives to the 

current system, a return-free tax system may be difficult to implement. 

• Enforcing the tax code: Perhaps the government’s most challenging role in 

administering the tax system is detecting and penalizing taxpayer noncompliance. 

Under the current system, withholding and information reporting are important 

enforcement tools that generally increase compliance rates. However, they are not 

sufficient by themselves, and IRS devotes considerable resources to collecting 

taxes owed but not remitted.

• Providing taxpayer assistance: In order to reduce compliance burden and 

increase compliance rates, tax administrators generally provide assistance to 

taxpayers by such means as publishing forms and answering questions.

A tax change proposal may reduce the cost of some administrative tasks but raise 

others. Compared to the current personal income tax, consumption taxes like an 

NRST or a VAT reduce the number of filers because only businesses file. As a result, 

they reduce processing costs and eliminate the compliance burden on individual 

taxpayers. However, other aspects of enforcement costs may increase because 

administrators would no longer be able to rely on withholding and information 

returns as enforcement tools.

The way the tax system is structured by Congress can affect how it is administered, 

and this can affect compliance. For example, taxes withheld from employees and 

taxes that have information reporting requirements have lower income misreporting 

rates than other taxes. As figure 15 shows, taxes on wage and salary income, which is 

subject to both withholding and information reporting, have the lowest rate of 

misreported income; whereas taxes on income from such sources as self-employment 

(nonfarm proprietor income) have the highest rate of misreported income. 
Section 2: Criteria for a Good Tax System

GAO-05-1009SP 51

Figure 15: Taxpayer Noncompliance Categorized by Amount of Withholding and Information 

Reporting, 1992

Regardless of the amount of withholding and third-party information reporting

required, other government enforcement activities are likely to be needed under any 

proposed tax system in order to ensure that taxpayers comply with the tax code. 

Proposals that simplify the tax code and administrative efforts to aid honest 

taxpayers in complying with the tax laws could increase compliance; however, under 

any system, costly enforcement efforts, perhaps including face-to-face audits of 

taxpayers, will likely always be needed to help detect and penalize dishonest 

taxpayers.

Measuring administrative costs is difficult. Budgetary costs are easily measured: IRS’s 

budget in fiscal year 2004 was $10.2 billion. However, as discussed earlier, the costs of 

other parties in tax administration are harder to determine. Compliance burden 

estimates range from $100 billion to $200 billion. Despite the uncertainty, the range of 

estimates indicates that compliance burden is likely to considerably outweigh IRS’s 

budgetary costs. 

0.9

4.2

7.1

31.8

• Wages and salaries • Pensions and annuities

• Dividend income

• Interest income

• Unemployment 

compensation

• Social Security benefits

• Credits 

• Deductions

• Partnership/S-Corp 

 income

• Exemptions

• Capital gains

• Alimony income

• Nonfarm proprietor 

 income 

• Informal supplier 

 income 

• Other income

• Rents and royalties

• Farm income

• Form 4947 income 

 adjustments

Percentage of misreported income

Source: IRS.

Substantial 

information reporting

Some information 

reporting

Little or no 

reporting

Substantial 

information reporting 

and withholding

0

5

10

15

20

25

30

35
Section 2: Criteria for a Good Tax System

 52 GAO-05-1009SP 

Changes in the technology of tax administration and in the tax code may have had 

offsetting and, as yet, unmeasured effects on the costs of tax administration. On the 

one hand, recent innovations in computer software and electronic financial 

transactions have made it easier to administer the tax code. On the other hand, since 

the last major tax reform initiative in 1986, the number of special rates, credits, 

deductions, and other provisions in the tax code have increased. This added 

complexity has made the tax code more difficult to administer. 

Trade-offs between Equity, Economic Efficiency, and Simplicity, 

Transparency, and Administrability

While the concept of administrability is closely linked to the concepts of simplicity 

and transparency, they are not always the same. For example, a national retail sales 

tax would be a relatively simple form of taxation for taxpayers to understand. At the 

same time, a national retail sales tax could present administrative difficulties because 

it would be difficult to distinguish between similar commodities that are tax exempt 

and those that are not, and to distinguish retail sales, which are taxed, from sales to 

other companies, which are not taxed. 

Similarly, just because a tax is administrable does not necessarily mean it would be 

transparent. For example, although payroll taxes are fairly easy to administer, who 

pays them in an economic sense is not necessarily transparent. As we discussed 

earlier, many economists agree that employees bear the entire burden (both the 

employer and employee share) of payroll taxes, making the incidence of payroll taxes 

nontransparent. 

Improving the simplicity, transparency, and administrability of the tax system may 

affect the equity and efficiency of the tax system. Simplified, transparent, and 

administrable tax codes are generally thought to enhance efficiency because

(1) taxpayers can redirect resources that would have been used to comply with the 

tax code to other, more productive purposes and (2) these tax systems have fewer 

incentives that distort decision making about work, savings, and investment. 

However, proposals to simplify the tax system may reduce equity because many tax 

provisions that are complex and difficult to comply with are also designed to promote 

fairness. 

Key Questions 

1. What impact is the tax proposal likely to have on the compliance burden that 

taxpayers face? 

• Will more or fewer taxpayers be required to fill out tax forms and file them 

with IRS? 

• What information will taxpayers be required to provide on the tax forms?

• Does the proposal contain any estimates of its effect on compliance burden?
Section 2: Criteria for a Good Tax System

GAO-05-1009SP 53

2. Will taxpayers’ planning responsibilities (record keeping, research, etc.) likely 

increase or decrease in comparison to those under the current tax system? 

3. Is the proposed tax system transparent?

• Can taxpayers identify their tax liability easily?

• Can taxpayers understand the logic behind the tax that they are paying? 

• Do taxpayers know what their true tax burden is (i.e., do they understand the 

incidence of the tax system)?

• Do taxpayers understand the incidence of the tax system in terms of the tax 

burdens of other taxpayers?

• Are taxpayers aware of the extent of compliance by others? 

4. How would the tax system be administered?

• What would be the role of taxpayers, employers, information return providers, 

and the IRS under the proposal?

• Does the proposal contain estimates of its effect on budgetary costs?

• Does the proposal contain any information about how administrative costs 

would be shared?

5. What would be the proposal’s impact on IRS?

• How would IRS functions of processing, compliance, collections, and taxpayer 

assistance be affected?

• What enforcement tools (e.g., withholding and information reporting) would 

be added or taken away from tax administrators?

• Does the proposal contain information about its likely effect on compliance? 

6. Are there trade-offs between the simplicity, transparency, and administrability of 

the proposed tax system? 

7. Under the tax proposal, have efforts to enhance the simplicity, transparency, and 

administrability of the tax system resulted in trade-offs with respect to the equity 

and efficiency of the proposal? 
54 GAO-05-1009SP 

Transitioning to a Different Tax System Secotin3

Transition rules are sometimes proposed when switching to an alternative tax 

system. The rules are often intended to compensate certain people or entities whose 

losses are determined to be inequitable. However, not all tax experts agree that 

transition rules are appropriate when implementing changes to the tax code. Since 

transition rules are short-term tax policies, they should be judged by the same criteria 

for a good tax system that we discussed earlier. Many of the same trade-offs between 

the criteria that exist when considering tax reform proposals are also relevant when 

considering how to move from the current tax system to an alternative tax system. 

(See fig. 16.)

Figure 16: Transition Issues Overview

Deciding if Transition Relief Is Necessary

Changes to the tax code can create winners and losers. Taxpayers’ losses, which are 

more often discussed in debates than gains resulting from tax policy changes, may be 

more obvious when tax changes increase government revenues or if the changes are 

Issues to consider when thinking 

about tax system changes:

Revenue 

Criteria for a good tax system:

• Equity 

• Economic efficiency 

• Simplicity, transparency, 

 and administrability

Transition effects

Sources: GAO (text); Dynamic Graphics (images).

 hanges to the tax system are 

likely to create winners and 

losers, and the government 

may attempt to mitigate large 

gains and losses by 

implementing transition 

rules. The following 

are issues to consider 

when thinking about 

transitioning to an 

alternate tax system:

Determining if transition 

relief is necessary

Identifying affected parties

Revenue effects of 

transition rules

Policy tools for 

transition period
Section 3: Transitioning to a Different Tax System

GAO-05-1009SP 55

designed to be revenue neutral. However, even tax decreases can create losers 

depending on whether the tax burden is redistributed, spending cuts are made, or the 

tax burden on future generations is increased. Deciding if transition relief is 

necessary involves how to trade off between equity, efficiency, simplicity, 

transparency, and administrability. 

Decisions about whether to tax previously accumulated savings when switching to a 

consumption tax provide an example of the trade-offs that need to be considered 

when determining if transition relief is merited. Some argue that switching from the 

current tax system to a consumption tax would merit some transition relief for equity 

reasons because accumulated savings, which may have already been taxed once 

under the income tax system, would be subject to a second tax when used for 

consumption purposes. In other words, those who had saved previously would be 

taxed higher than those just beginning to save. Proponents for transition relief argue 

that taxpayers who accumulated savings have an implicit contract with the 

government that savings would not be taxed when withdrawn. The notion that 

taxpayers rely on the continued existence of government policy when they make 

economic decisions is one of the key equity justifications for offering transition relief. 

However, not everyone agrees that transition relief is justifiable based on equity 

grounds. Opponents of transition relief argue that taxpayers knowingly accept the 

risk that government policy may change when they make decisions, such as how 

much to save, and therefore do not need to be compensated for any losses that result 

from switching to an alternative tax system. 

There are also trade-offs between equity and efficiency that should be considered 

when thinking about transition relief. The efficiency gains that could be realized by 

switching to a consumption tax could be negated if the government offered transition 

relief to taxpayers. Taxing accumulated savings is economically efficient because 

doing so does not distort work or savings behavior—taxpayers cannot avoid paying 

the tax by changing their behavior to work or save less. Offering transition relief 

would reduce the revenue gain from taxing accumulated savings, thereby requiring 

higher consumption tax rates.

Finally, developing and implementing transition rules could add a significant amount 

of complexity to the tax system—a characteristic of the tax system that the switch to 

an alternative tax system was likely intended to reduce. The new complexity would 

be temporary, phasing out with the transition rules.

Identifying Affected Parties

Identifying winners and losers, the amount of gains and losses, and effective 

mitigation policies is complicated by the different ways tax changes can affect 

taxpayers. Tax law changes, by definition, affect taxpayers’ future liabilities. In some 

cases, those future tax changes are capitalized into the prices of marketable assets. 
Section 3: Transitioning to a Different Tax System

 56 GAO-05-1009SP 

For example, changes in the tax treatment of owner-occupied housing have the 

potential to affect current housing prices. In other cases, such as wealth accumulated 

in a savings account, tax law changes might affect the value of the wealth but do not 

change the price of a marketable asset. In still other cases, the after-tax return to 

future behavior, such as hours worked, is altered. Regardless of how taxpayers feel 

the impact of a tax change, the impact on their ability to consume over time is the 

same (assuming everything else is constant).

Revenue Effects of Transition Relief

If transition relief is provided to compensate taxpayers for financial losses due to 

changes in the tax code, then revenues equivalent to these losses will need to be 

found from other sources, assuming the proposal is revenue neutral. One alternative 

source of revenue would be to tax those who have received windfall gains from the 

policy changes. However, debates about transition relief typically center around how 

to handle taxpayers who are likely to suffer windfall losses and not on how to impose 

special taxes on those who experience windfall gains. 

Policy Tools for Implementing Transition Rules

The two most commonly discussed policy tools for transitioning to an alternative tax 

system are grandfather clauses and phase-in rules. 

• Grandfather clauses: Grandfather clauses are typically used to exempt people 

who would be subject to a new rule from the provisions of that rule. Grandfather 

clauses are generally used to exempt current assets or investments from new tax 

rules in order to protect taxpayers who purchased those assets from being 

penalized by unexpected changes to the tax system. One problem with 

grandfather clauses is that over time they can lead to unequal tax treatment of 

similar assets. 

• Phase-in periods for new laws: Another form of transition relief would be to 

phase in new legislation over a period of time in order to reduce the effects that 

new tax laws would have on taxpayers. 

• Combination of grandfather clauses and phase-in periods: It would also be 

possible to develop transition rules that allow for certain assets/investments to be 

grandfathered and others subject to phased-in tax laws. One possible variant 

previously outlined by the Treasury Department would be to apply new tax laws 

immediately to all new assets but phase in the tax laws on existing assets. 
Section 3: Transitioning to a Different Tax System

GAO-05-1009SP 57

Key Questions

1. Does the proposal include transition rules? 

• If so, what are they? 

• What gains and losses are the rules intended to mitigate?

• Who bears these gains or losses?

2. What are the expected revenue effects of the transition rules? 

• If the proposal is intended to be revenue neutral, what additional revenue 

sources will be used during the transition period?

3. How will the transition rules affect the equity of the tax system as a whole?

• Why were some taxpayers selected for transition relief but not others?

• Who will pay for the transition relief?

4. How will the transition rules affect the overall efficiency of the tax system?

• Do the transition rules have efficiency costs that offset some of the gains from 

changing the tax system?

• Do estimates of these efficiency costs exist?

5. How will the transition rules affect the overall simplicity, transparency, and 

administrability of the tax system?
58 GAO-05-1009SP 

Appendix I: Key Questions AAppenednxidexiIs

Section I: Revenue Needs—Taxes Exist to Fund 

Government 

1. What current taxes would the proposal change?

• Does the proposal change personal income taxes, social insurance taxes, 

corporate income taxes, and/or estate and gift taxes?

2. What is the nature of the proposed change to the tax system?

• Does the proposal change the tax base from income to consumption?

• Does the proposal include tax expenditures?

• Does the proposal change the tax rates?

• Does the proposal change the collection points for the tax?

3. How will the proposed change affect total revenues?

• Are proposed changes to the tax code likely to be revenue neutral? 

• If not, will they generate more or less revenue than the current tax laws? 

4. What effect would the proposal have on the nation’s projected budgets and longterm fiscal outlook? 

• Does the proposal take into consideration the sizable long-term fiscal gap that the 

country faces?

5. What tax expenditures are included in the proposal, and what tax expenditures, if 

any, have been removed from the current tax system?

• Are the social and economic goals of the tax expenditures likely to be achieved 

and worth the cost in lost revenue?

• When the total costs of a program are considered, would it be less costly to 

implement the program as a tax expenditure or as a spending program?

6. If the proposal changes the tax base, the tax rates, or the collection points, how 

would these changes alter the amount of revenue that the government is able to 

collect? 

7. What implications, if any, would the proposal have on the ability of state and local 

governments to collect tax revenues? 
Appendix I: Key Questions

GAO-05-1009SP 59

• Would the proposal tax the same base that many states rely on?

• Would the proposal allow many states to continue to rely on the federal tax 

base as a starting point for determining state taxes? 

Section II: Criteria for a Good Tax System

Equity

1. How is a taxpayer’s ability to pay broadly defined: 

• Income?

• Consumption?

• A broader definition of overall wealth? 

2. What factors other than income, such as medical expenses, number of 

dependents, and so forth, does the proposal account for when considering a 

taxpayer’s ability to pay taxes?

3. Will taxpayers with equal ability to pay taxes pay the same amount?

• If not, what provisions of the proposal do not adhere to the principle of 

horizontal equity? 

4. How will the tax system tax people with differing ability to pay?

• Are the statutory tax rates progressive, proportional, or regressive?

• Are the average effective tax rates progressive, proportional, or regressive 

(accounting for credits, deductions, and other tax expenditures)?

5. Are there any components of the tax proposal that are justified on the benefits 

received principle? 

• If so, what mechanisms are in place to determine that taxpayers who pay taxes 

for a particular government program are the same taxpayers who benefit from 

the provisions of that program?

6. Does the proposal change the distribution of taxes (i.e., is the proposal 

distributionally neutral)?

• If not, who will be paying more in taxes and who will be paying less?

• If so, what features of the proposal are in place to ensure that it will remain 

distributionally neutral?

7. What type of distributional analysis was done?
Appendix I: Key Questions

60 GAO-05-1009SP 

• What time period is covered? For example does the distributional analysis 

measure the lifetime or annual effects of the tax system?

• How is ability to pay (income, consumption, or wealth) measured?

• What is the unit of analysis (individuals, households, or taxpaying units, etc.)?

• What assumptions are made about tax incidence (e.g., who is assumed to pay 

the corporate income tax)?

• What taxes are covered in the distributional analyses? 

• What measures (e.g., tax rates, share of tax liability) are being used to calculate 

the distribution of tax burden? 

Efficiency

1. Does the proposal tax income, spending, assets, and investments differentially?

• Which types of income, spending, assets, and investments are tax preferred?

• Which decisions are likely to be distorted?

2. What social goals, if any, is the tax proposal trying to promote? 

• Is there an efficiency justification for the goal, or is the goal justified on other 

grounds, such as equity?

3. Do estimates of the cost of achieving the goal include efficiency costs?

4. What are the trade-offs between equity, efficiency, and the other criteria? 

5. Is the tax proposal accompanied by estimates of the efficiency gains or losses to 

be realized by the new tax system? 

• Is the tax proposal accompanied by estimates of economic activity (e.g., 

change in labor supply or change in gross domestic product (GDP)) that will be 

encouraged or discouraged by the new tax system?

• Is the proposal accompanied by estimates of the efficiency loss or gain 

associated with these changes in economic activity?

6. How does the tax change affect leisure versus work decisions?

7. How does the tax change affect savings versus consumption decisions?

8. How does the tax system affect decisions about foreign versus domestic 

investment?

9. How does the tax change affect choices between different types of investments 

and different types of consumption? 
Appendix I: Key Questions

GAO-05-1009SP 61

10. Is the tax proposal likely to increase economic growth? 

• Is the growth achieved through a onetime rearranging of resources? 

• Is the growth achieved through a permanent increase in the rate of growth?

• Does the tax proposal contain estimates of its effect on growth (often 

measured by changes in GDP) and estimates of the costs of achieving the 

growth (such as reduced leisure time)?

11. In addition to efficiency effects, will the proposal have other economic effects by 

increasing or reducing the deficit?

Simplicity, Transparency, and Administrability

1. What impact is the tax proposal likely to have on the compliance burden that 

taxpayers face? 

• Will more or fewer taxpayers be required to fill out tax forms and file them 

with the Internal Revenue Service (IRS)? 

• What information will taxpayers be required to provide on the tax forms?

• Does the proposal contain any estimates of its effect on compliance burden?

2. Will taxpayers’ planning responsibilities (record keeping, research, etc.) likely 

increase or decrease in comparison to those under the current tax system? 

3. Is the proposed tax system transparent?

• Can taxpayers identify their tax liability easily?

• Can taxpayers understand the logic behind the tax that they are paying? 

• Do taxpayers know what their true tax burden is (i.e., do they understand the 

incidence of the tax system)?

• Do taxpayers understand the incidence of the tax system in terms of the tax 

burdens of other taxpayers?

• Are taxpayers aware of the extent of compliance by others? 

4. How would the tax system be administered?

• What would be the role of taxpayers, employers, information return providers, 

and the IRS under the proposal?

• Does the proposal contain estimates of its effect on budgetary costs?

• Does the proposal contain any information about how administrative costs 

would be shared?

5. What would be the proposal’s impact on IRS?
Appendix I: Key Questions

62 GAO-05-1009SP 

• How would IRS functions of processing, compliance, collections, and taxpayer 

assistance be affected?

• What enforcement tools (e.g., withholding and information reporting) would 

be added or taken away from tax administrators?

• Does the proposal contain information about its likely effect on compliance? 

6. Are there trade-offs between the simplicity, transparency, and administrability of 

the proposed tax system? 

7. Under the tax proposal, have efforts to enhance the simplicity, transparency, and 

administrability of the tax system resulted in trade-offs with respect to the equity 

and efficiency of the proposal? 

Section III: Transitioning to a Different Tax System

1. Does the proposal include transition rules? 

• If so, what are they? 

• What gains and losses are the rules intended to mitigate?

• Who bears these gains or losses?

2. What are the expected revenue effects of the transition rules? 

• If the proposal is intended to be revenue neutral, what additional revenue 

sources will be used during the transition period?

3. How will the transition rules affect the equity of the tax system as a whole?

• Why were some taxpayers selected for transition relief but not others?

• Who will pay for the transition relief?

4. How will the transition rules affect the overall efficiency of the tax system?

• Do the transition rules have efficiency costs that offset some of the gains from 

changing the tax system?

• Do estimates of these efficiency costs exist?

5. How will the transition rules affect the overall simplicity, transparency, and 

administrability of the tax system?
GAO-05-1009SP 63

Appendix II: Selected Bibliography and 

Related Reports ApendxIi

Government Accountability Office

Government Performance and Accountability: Tax Expenditures Represent a 

Substantial Federal Commitment and Need to Be Reexamined. GAO-05-690

(Forthcoming). 

Tax Policy: Summary of Estimates of the Costs of the Federal Tax System. GAO-05-

878 (Forthcoming).

Tax Compliance: Reducing the Tax Gap Can Contribute to Fiscal Sustainability 

but Will Require a Variety of Strategies. GAO-05-527T. Washington, D.C.: April 14, 

2005.

21st Century Challenges: Reexamining the Base of the Federal Government. GAO05-325SP. Washington, D.C.: February 1, 2005.

Federal Debt: Answers to Frequently Asked Questions—An Update. GAO-04-485SP. 

Washington, D.C.: August 12, 2004.

The Honorable David M. Walker, Comptroller General of the United States. Truth and 

Transparency: The Federal Government’s Financial Condition and Fiscal Outlook. 

Address to the National Press Club. September 17, 2003.

Alternative Minimum Tax: An Overview of Its Rationale and Impact on 

Individual Taxpayers. GAO/GGD-00-180. Washington, D.C.: August 15, 2000.

Tax Administration: Potential Impact of Alternative Taxes on Taxpayers and 

Administrators. GAO/GGD-98-37. Washington, D.C.: January 14, 1998.

Congressional Budget Office 

Statement of Douglas Holtz-Eakin, Director. The Economic Costs of Long-Term 

Federal Obligations. Washington, D.C.: February 16, 2005.

Effective Tax Rates: Comparing Annual and Multiyear Measures. Washington, 

D.C.: January 2005.

Effective Federal Tax Rates Under Current Law, 2001 to 2014. Washington, D.C.: 

August 2004.
Appendix II: Selected Bibliography and Related 

64 GAO-05-1009SP 

Selected Bibliography and Related Reports

Revenue and Tax Policy Brief: The Alternative Minimum Tax, No. 4. Washington, 

D.C.: April 15, 2004.

Effective Federal Tax Rates, 1997 to 2000. Washington, D.C.: August 2003.

Options to Cut Taxes. Washington, D.C.: June 2000.

The Incidence of the Corporate Income Tax. Washington, D.C.: March 1996.

Library of Congress, Congressional Research Service

Esenwein, Gregg A. and Jane G. Gravelle. The Flat Tax, Value-Added Tax, and 

National Retail Sales Tax: Overview of the Issues. CRS Report RL32603. 

Washington, D.C.: December 14, 2004.

Esenwein, Gregg A. The Alternative Minimum Tax for Individuals. CRS Report 

RL30149. Washington, D.C.: November 15, 2004.

Labonte, Marc. The Size and Role of Government: Economic Issues. CRS Report 

RL32162. Washington, D.C.: March 22, 2005.

Luckey, John R. Federal Estate, Gift, and Generation-Skipping Taxes: A 

Description of Current Law. CRS Report 95-416. Washington, D.C.: January 5, 2005.

Other Selected Sources

Aaron, Henry J. and William G. Gale. Economic Effects of Fundamental Tax Reform. 

Washington, D.C.: Brookings Institution Press, 1996.

Cai, Jinyong and Jagadeesh Gokhale. “The Welfare Loss From a Capital Income Tax.” 

Federal Reserve Bank of Cleveland Economic Review, vol. 33, no. 1 (1997).

Cronin, Julie-Anne. U.S. Treasury Distributional Analysis Methodology, Office of 

Tax Analysis Paper 85. Washington, D.C.: U.S. Department of the Treasury, 

September 1999.

Feldstein, Martin, “Tax Avoidance and the Deadweight Loss of the Income Tax.” The 

Review of Economics and Statistics, vol. 81, no. 4 (1999): 674-680.

Gravelle, Jane G., “The Corporate Tax: Where Has It Been and Where Is It Going?” 

National Tax Journal, vol. 57, no. 4 (2004): 903-23.

Joint Committee on Taxation, Methodology and Issues in Measuring Changes in the 

Distribution of Tax Burdens. JCT Report JCS-7-93. Washington, D.C.: June 1993. 
Appendix II: Selected Bibliography and Related Reports

GAO-05-1009SP 65

Mikesell, John L. Fiscal Administration: Analysis and Application for the Public 

Sector, 5th Edition. Fort Worth, Tex.: Harcourt Brace Publishers, 1999.
GAO-05-1009SP 66

Appendix III: Glossary ApendxiI

Ability to Pay Principle A concept of tax fairness that states that people with different 

amounts of wealth, income, or other levels of well-being should pay 

tax at different rates. Wealth includes assets such as houses, cars, 

stocks, bonds, and savings accounts. Income includes wages, 

interest, dividends, and other payments.

Adjusted Gross Income (AGI) All income subject to taxation under the individual income tax after 

subtracting certain deductions, such as certain contributions for 

individual retirement accounts, and alimony payments. Personal 

exemptions and the standard or itemized deductions are also 

subtracted from AGI to determine taxable income.

Alternative Minimum Tax (AMT) A separate tax system that applies to both individual and corporate 

taxpayers. It parallels the income tax system but with different rules 

for determining taxable income, different tax rates for computing tax 

liability, and different rules for allowing the use of tax credits.

Average Tax Rates The total amount of tax a taxpayer pays divided by some measure 

of his or her income. In the current tax system, average tax rates 

are sometimes presented as the amount of tax a taxpayer pays 

divided by his or her taxable income. Average effective tax rates 

differ in that they are developed using a broader measure of total 

income than taxable income.

Benefits Received Principle A concept of tax fairness that states that people should pay taxes in 

proportion to the benefits they receive from government goods and 

services.

Capital Gains A capital asset's selling price less its initial purchase price. 

Investments that have been sold at a profit are called realized 

capital gains. Investments that have not yet been sold, but would 

yield a profit if they were sold have unrealized capital gains.

Collection Point The individual or business that actually remits payment of taxes to 

the government.

Compliance Burden The time and resources, including out-of-pocket costs, that 

taxpayers spend each year in order to comply with the tax laws. 

Compliance burden is often cited as a measure of the overall 

simplicity of the tax code. 

Consumption Tax Base A tax base where people pay taxes on goods and services that they 

purchase, or consume, effectively excluding savings and 

investment from the tax base. Capital assets are usually fully 

expensed when purchased under a consumption tax rather than 

depreciated over time, as is the case under an income tax.

Corporate Income Taxes Taxes paid by corporations on net income, or the difference 

between corporate revenues and corporate business expenses.

Credit An amount that offsets or reduces tax liability. When the allowable 

credit amount exceeds the tax liability, and the difference is paid to 

the taxpayer, the credit is considered refundable.

Deduction An amount that is subtracted from the tax base before tax liability is 

calculated. Deductions claimed before and after the adjusted gross 

income line on the Form 1040 are sometimes called “above the 

line” and “below the line” deductions, respectively.

Deficit The amount by which the government's spending exceeds its 

revenues for a given period, usually a fiscal year.
Appendix III: Glossary

GAO-05-1009SP 67

Defined Contribution Pension 

Plans

A type of retirement plan that establishes individual accounts for 

employees to which the employer, participants, or both make 

periodic contributions. Employees bear the investment risk and 

often control, at least in part, how their individual account assets 

are invested.

Discretionary Spending Outlays controlled by appropriation acts, other than those that fund 

mandatory programs.

Distortion Changes in behavior, such as how much to work, what to consume, 

and where to invest, due to taxes, government benefits, or 

monopolies. 

Distributional Analysis An analytical tool used by government agencies and other analysts 

to identify how different tax proposals or tax systems would affect 

different groups of taxpayers with differing ability to pay taxes, 

usually measured by income.

Dividend Income A taxable payment made by a company to its shareholders, often 

quarterly, out of the company’s retained earnings. Dividends are 

usually given out in the form of cash, but can also be given out as 

stock or other property.

Economic Incidence The person or group of people that actually bear the burden of a tax 

regardless of who remits payment to the government. For example, 

even though businesses remit tax sales tax payments to the 

government, individuals who purchase items may bear the actual 

burden of the tax.

Effective Tax Rates The amount of tax that a taxpayer pays to the government 

expressed as a percentage of some overall measure of total 

income.

Efficiency Costs A reduction in economic well-being caused by distortions, or 

changes in behavior due to taxes, government benefits, 

monopolies, and other forces that interfere in the market. Efficiency 

costs can take the form of lost output or consumption opportunities.

Employer-Provided Health Care Insurance plans offered by employers to employees where the 

employer pays all or a portion of an employee’s health insurance 

costs. Employer-provided health care payments are not counted as 

nonwage income, and therefore these payments are not subject to 

taxation.

Entitlement Programs that require the payment of benefits to persons, state or 

local governments, or other entities if specific criteria established in 

the authorizing law are met.

Estate and Gift Taxes Assets an individual owns at the time of his or her death or gifts 

made during the course of his or her life may be subject to transfer 

taxes, sometimes referred to as estate and gift taxes. Estate and 

gift taxes are more likely to affect wealthier individuals, and most 

citizens are unaffected by estate and gift taxes.

Excise Taxes A tax on the sale or use of specific products or transactions.

Exemption A part of a person's income on which no tax is imposed. It is the 

amount that taxpayers can claim for themselves, their spouses, and 

eligible dependents. There are two types of exemptions—personal 

and dependency. Each exemption reduces the income subject to 

tax. The exemption amount is a set amount that changes from year 

to year.

Externality A benefit or cost that is not captured or paid by the individuals or 

firms creating them.
Appendix III: Glossary

68 GAO-05-1009SP 

Flat Tax A type of tax reform proposal that, in most cases would change the 

tax base to a consumption tax base and impose a single, or flat, tax 

rate on individuals and businesses. Most flat tax proposals would 

not really be “flat” because they grant exemptions for at least some 

earnings.

Grandfather Clause Provisions that are typically used to exempt people who would be 

subject to a new rule from the provisions of that rule. Thus, in the 

case of tax law changes, only people who engage in certain 

activities after a tax law change will be affected by changes to the 

tax treatment of that activity.

Gross Domestic Product (GDP) The value of all final goods and services produced within the 

borders of a country such as the United States during a given 

period. The components of GDP are consumption expenditures 

(both personal and government), gross investment (both private 

and government) and net exports.

Horizontal Equity The concept that people with the same ability to pay should be 

taxed at the same rate.

Income Tax Base A tax base where individuals are taxed on the basis of income, or 

both the goods and services they consume as well as their savings 

and investments. Under an income tax, capital assets are usually 

depreciated over time rather than being fully expensed at the time 

they are purchased, as would be the case under a consumption 

tax.

Individual Retirement Accounts Investment accounts that allow people to save a certain amount of 

income each year and, in most cases, deduct the savings from 

taxable income, with the savings and interest tax deferred until the 

person retires.

Mandatory Spending Also known as “direct spending.” Mandatory spending includes 

outlays for entitlements (for example, food stamps, Medicare, and 

veterans’ pension programs), interest payments on the public debt 

and nonentitlements such as payments to the states from Forest 

Service receipts. By defining eligibility and setting the benefit or 

payment rules, the Congress controls spending for these programs 

indirectly rather than through appropriations acts. 

Marginal Tax Rates Tax rate that taxpayers pay on the next dollar of income that is 

earned. Marginal tax rates can be presented as both marginal 

statutory rates and marginal effective rates.

Medicaid A federal program that states administer to help pay medical costs 

for low income citizens. Each state in which applicants for the 

program reside establishes criteria for financial need. Medicaid 

supplements Medicare to pay for some of the costs that Medicare 

does not cover.

Medicare A federal entitlement program that delivers medical care to eligible 

workers, spouses of workers, and retired workers when they reach 

age 65. 

Net Tax Gap The difference between taxes legally owed to the government and 

taxes actually paid to the government, less collected enforcement 

revenue.

Payroll Taxes Often synonymous with social insurance taxes. However, in some 

cases the term “payroll taxes” may be used more generally to 

include all tax withholding. For the purposes of this report, payroll 

taxes are synonymous with social insurance taxes. 

Personal Income Taxes Taxes on income earned by individuals, including income from 

wages, interest, and nonwage income.
Appendix III: Glossary

GAO-05-1009SP 69

Phase-in Rule A rule that allows for a new tax provision to be implemented 

gradually rather than immediately upon enactment of a new tax law. 

Phase-in rules help mitigate windfall losses during the transition to 

a new set of tax laws.

Progressive Tax Rates A tax rate structure where tax liability as a percentage of income 

increases as income increases.

Proportional Tax Rates A tax rate structure where taxpayers pay the same percentage of 

income, regardless of their income.

Regressive Tax Rates A tax rate structure where tax liability is a smaller percentage of a 

taxpayer’s income as income increases.

Retail Sales Tax A tax levied on the sale price of a good and collected by the seller 

of the good.

Revenue Neutral A term applied to tax bills or proposals are designed to raise the 

same amount of revenue as the system that is being replaced.

Social Insurance Taxes Tax payments to the federal government for Social Security, 

Medicare, and unemployment compensation. While employees 

and employers pay equal amounts in social insurance taxes, 

economists generally agree that employees bear the entire burden 

of social insurance taxes in the form of reduced wages.

Spillovers See externality.

Standard Deduction A deduction that reduces income subject to tax and varies 

depending on filing status, age, blindness, and dependency. The 

standard deduction is taken instead of itemizing deductions.

Statutory Incidence The party, usually an individual or a business, that is legally 

required to pay a tax to the government.

Statutory Tax Rate Tax rates as written into law. 

Tax Burden See economic incidence.

Tax-Exempt Bonds Bonds issued by state and local governments for public projects on 

which interest that is earned is exempt from federal income tax.

Tax Expenditures A revenue loss attributable to a provision of the federal tax laws that 

grants special tax relief that encourages certain kinds of behavior 

by taxpayers or to aid taxpayers in special circumstances. The 

Congressional Budget and Impoundment Act of 1974 lists six types 

of tax expenditures: exclusions, exemptions, deductions, credits, 

preferential tax rates, and deferrals. 

Tax Incidence See economic incidence.

Tax Liability The amount of tax that a taxpayer is legally required to pay to the 

government at a given time.

Tax Preferences See tax expenditures.

Taxable Income Income subject to tax that is used to determine tax liability. In the 

case of the federal income tax, taxable income is equal to a 

taxpayer’s adjusted gross income less personal deductions and 

exemptions.

Third-Party Information 

Reporting

Information reported to IRS by third parties, such as banks or 

employers, that allows IRS to verify that information reported by 

taxpayers on their tax returns is accurate. 

Value-Added Tax A tax levied at each stage of production or distribution on the value 

added to the product during that stage of production. Value-added 

taxes are now commonly used in many Western European 

countries as a source of revenue.
Appendix III: Glossary

70 GAO-05-1009SP 

Vertical Equity The concept that people with differing ability to pay taxes should 

pay different rates of taxes or different percentages of their incomes 

in taxes.

Voluntary Compliance A system of compliance that relies on individual citizens to report 

their income freely and voluntarily, calculate their tax liability 

correctly, and file a tax return on time.

Windfall Gain A sudden and usually unexpected gain for a taxpayer or group of 

taxpayers owing to changes to the tax system.

Windfall Loss A sudden and usually unexpected loss for a taxpayer or group of 

taxpayers owing to a change in the tax system. Transition rules are 

often proposed to mitigate the effects of windfall losses.
GAO-05-1009SP 71

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